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What you really need to know before investing for dividends

by , 19 August 2015

One of the main reasons why you choose to invest a stock is that you believe it'll go up in price over time.

If you're an income investor, another factor you may consider is the dividend the stock pays.

That's why, if a company cuts its dividend, you can be sure its share price will drop. Investors that were in the stock for the dividends will sell their shares.

For example: Take commodity giant Kumba Iron Ore (JSE: KIO). In February 2014, the company announced a 42% cut in its dividend pay-out.

To make matters worse for Kumba investors; on the 21st of July 2015, the group axed its dividend for the first time, since 2006.

This had a big impact on investors and immediately affected Kumba's share price. By the 24th of July, Kumba's share price dropped 16%.

Anglo American Platinum (JSE: ANG) suffered a similar fate. In 2009, Anglo's share price fell 17% on the day the group suspended its dividend.

Now I'm guessing you don't want to suffer a similar fate with your stocks.

Do you?

Beware of this dividend trap

The first thing you might look at when finding a stock that pays good dividends is the dividend yield.

Usually a stock with a high dividend yield is said to be "attractive" and more likely to pay out dividends to its shareholders.

However, this isn't always the case.

Take Kumba as an example. Last year, its dividend yield was around 11%, which is very high compared to the average stock's dividend. Yet it still cut back on its dividend policy.

Basically, Kumba's dividend yield had no bearing on the stock's reliability.

Now, if you're going to achieve your financial goals by investing in dividend paying stocks, you do need a decent pay out.

But first, you need to see if you're going to receive any dividends at all. To find out if the dividend is sustainable, you can look at the pay-out ratio.

The pay-out ratio is the percentage of earnings that’s paid out in dividends. To work this out, simply take the dividends paid and divide it by net income.

But you can go even further than this…

When it comes to dividends, cash flow is king

There's a better way to determine if your dividends are safe. When calculating the pay-out ratio, simply replace net income with cash flow from operations.

Cash flow from operations tells you how much cash the company generated from the day-to-day running of the business. Capital expenditures is what the company spent on equipment, facilities, etc.

So if you subtract capital expenditures from cash flow from operations, you'll get the free cash flow.

You want free cash flow to be higher than dividends paid. If it is not, that means the company doesn’t generate enough cash to pay its dividend.

So you need to aim for pay-out ratio (using cash flow) of 75% or lower. That way, even if the company has a downturn the following year, it should still be able to pay the dividend.

Three other ways to confirm a company's ability to consistently pay you dividends

#1: Consistent dividend growth is crucial – you can take a look at the dividend payment history of each company.

You can eliminate companies that slashed their dividend at any time during that time period.

Why? Because if they reduced their dividend one time, they may decide to do so again.

#2: Make sure the company doesn’t use its debt to pay dividends – companies sometimes have low profits or cash flow problems and then pay out dividends using debt.

This is a big no-no and something to stay away from at all costs.

#3: Rather be safe, than sorry – you could also refine your search for strong dividends by removing very small companies. Such companies may face huge competition from larger companies in their sectors.

So, a steady dividend from them is less than a sure thing.

Just remember, dividends are paid with cash and not earnings.

Cash flow shows you how much cash the company took in. And that's what it uses to pay dividends. So when determining the safety of your dividend, it's the first thing you should look at.

What you really need to know before investing for dividends
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