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
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
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.
In some cases, utilities have other long-term commitments beyond debt to uphold. Southern Company
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
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!
Fool contributor Dan Caplinger likes companies that stay within their budgets. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management and Southern Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You'll always be able to afford The Fool's disclosure policy.