Thanks to recent tax law changes, the much-maligned symbol of old economy stocks -- the dividend -- is making a comeback. Investors are taking a fresh look at dividends now that they're taxed at the capital gains rate, with some exceptions, and not as income.
The result? Through Nov. 2003, close to 1,500 U.S. companies increased dividends, the most since 1999, and a significant number considering we're less than two years out of a recession. Some well-known companies boosted payouts dramatically, including McDonald's
I'm a proponent of holding at least some dividend-paying stocks in your portfolio, and, of course, the Motley Fool Income Investor has some good candidates. Dividends provide a real cash return that, in down markets, is like manna from heaven. Of course, you have to be careful (isn't that always the case?), because as Bill Mann points out, not all dividends are created equal.
Dividend yield is a good proxy for risk, and the market often anticipates dividend cuts before they happen. The market sometimes overreacts, offering up good stocks at impressive yields, so here's the question you have to answer: How safe is the dividend payment? I use a few rules of thumb to judge dividend safety:
History of profitability This should be a no-brainer. If a company can't make a steady profit, eventually it won't make dividend payments either.
Free cash flow at least enough to cover dividend payments Dividends represent a portion of earnings, but they're paid with cash. Therefore, I like to see free cash flow at least twice the dividend payment, although I'll take less in special circumstances. Borrowing money to cover dividends is tempting for companies with poor free cash flow, and this is a big no-no.
- Debt coverage ratios at least industry average, preferably better This is very important, and is almost a corollary to the last factor. In an economic downturn, firms with poor coverage ratios risk not having sufficient cash flow to make interest payments, which can trigger the additional whammy of principal repayment. When companies run into this situation, guess who's not getting their dividend payments? Yep, you.
So, when you're shopping for high-yield stocks, use these criteria to separate the good deals from the bad. Your portfolio will thank you, and reward you.
Chris Mallon does not own any of the companies mentioned in this article.