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Dividend-paying stocks appeal to investors who want their portfolios to generate income. But for many investors, the appeal of dividends goes beyond simply getting cold hard cash in their pocket. Rather, a stock that consistently pays good-sized dividends projects a sense of financial health and stability, suggesting that a business produces enough cash to send out to shareholders quarter in and quarter out no matter what's happening in the overall economy.
But in many cases, stocks that pay impressive dividend yields are actually drawing money to help pay them from a different source: issuing shares into the secondary market. Companies do this for a variety of reasons, but until you understand why it's happening, it can cast a shadow over just how meaningful a healthy dividend yield is for investors looking for stability.
REITs and your money
You have to be careful about reading too much into dividend payouts any time you're dealing with a tax-favored entity that is required to pay dividends. In some cases, the accounting requirements of the tax laws governing those entities lead to erroneous conclusions.
For instance, real estate investment trusts are required to pay out at least 90% of their income in order to qualify for favorable pass-through tax treatment. This is a big deal, as it helps REITs avoid double taxation on their profits.
But in many parts of the REIT market, REITs don't want to part with that cash. For instance, Chimera Investment (NYSE: CIM ) , which invests largely in non-agency mortgage-backed securities, paid out far more in dividends than either its net income or its free cash flow. Yet in order to maintain its growth, Chimera issued shares worth about 90% of the payouts it made in the past year. That helped Chimera get by with only a tiny cash balance on its balance sheet.
With many REITs, it's even clearer that companies are making conscious choices to grow balance sheets while still adhering to tax regulations. At Annaly Capital (NYSE: NLY ) , free cash flow is enough to cover its huge dividend, but the company nevertheless issued more than enough new shares to make dividend payments without having to dip into cash reserves. Again, that helps Annaly and its peers leverage their balance sheets as much as possible.
Another industry that often resorts to newly issued shares is the utility sector. With big overhanging debt and expensive capital operations, utilities often need to find other sources of cash to finance part of their dividends.
PPL (NYSE: PPL ) , for instance, had free cash flow of just $20 million in 2011 but paid $746 million in dividends. It bridged that gap by issuing nearly $2.3 billion in new shares, some of which also went toward repaying long-term debt.
In some cases, utilities have other long-term commitments beyond debt to uphold. Southern Company (NYSE: SO ) issued more than $700 million in new shares last year to help finance $1.6 billion in dividends. The utility's free cash flow would almost have been sufficient to cover the payouts, but a contribution of nearly $2.3 billion toward a nuclear decommissioning trust fund consistently saps a big wad of cash every year.
Not all utilities resort to major share issuance. But the practice can avoid cash management problems and leave companies in better shape if something truly unexpected happens.
Snacking on dividends
Although many big share-issuing dividend payers are REITs and utilities, some other companies also use new shares from time to time to help finance payouts. Kraft Foods (NYSE: KFT ) , for instance, issued about half a billion dollars in shares to help it make more than $2 billion in dividend payouts. The company had more than enough free cash flow to cover dividends, but with Kraft's impending split into two separate companies, boosting its cash levels was probably part of the reason for making the decision.
Make the right call
It's important not to panic when you see regular share issuance. In most cases, it doesn't indicate an inability to afford dividend payouts, but rather represents a business decision to boost cash on hand or otherwise grow the size of a company. By understanding better how a company structures its inner financial workings, you'll be better able to see subtle changes that could spell future disruptions -- and presage what could eventually become threats to dividend payouts.
Even with the need for extra research, many dividend-paying stocks do indeed have the cash flow to sustain and grow their dividends over time. Read about some great examples in the Fool's special report on dividends, where you'll learn about nine stocks that will help you secure your future. It's free, so click here and get your copy today!