December 9, 2008 - Many stocks are paying dividends that give very high yields. It's tempting to buy a stock based solely on the yield, say 5% or more, when bank CD's are giving 2% or 3% without any potential for capital gains (or losses). But looking at just one number is never good enough. If you're after income, then by all means consider stocks, but be sure the dividend is safe.

Stocks that yield less may be a good investment. Those aren't the focus here. The ones that should concern any investor are the ones offering yields well above the average. In fact, the further from the average you are, the less likely the dividend will continue. The exceptions to this rule are stocks which focus on paying dividends such as utilities and Real Estate Investment Trusts, but let's put those aside for a moment.

Well above average yields should be a red flag for investors. And the higher the yield goes, the bigger the red flag should be. For example, if a stock is offering a yield of 8% in today's market, and it's not an REIT or utility, it's most likely that investors don't believe the company will continue paying it, and they're selling the stock. Of course, the lower the stock goes, the higher the yield gets. If investors felt the dividend were safe, they would bid the stock up, thereby lowering the yield. So venturing too far beyond the average for all stocks has its risks. Beware of any stock that has a yield that's more than twice the average.

The second data point to consider is the percentage of profits the dividend takes. In other words, if a dividend is 80% or 90% of profits, then it's very hard for companies that aren't growing to continue to pay at those levels (again, the exception would be the REIT, utilities and other industries that are set up just for dividends).

Remember that if a company is using profits to pay dividends, it has less capital to grow the company. Without growth in revenues and profits, there can't be growth in dividends.

A dividend that takes less than 50% of profits is much safer than one that takes 80% or 90%. The lower the percentage goes, the more likely an investor is to receive the pay out. Of course, if the company is paying only 10% of its profits in dividends and has a loss the next year, it's highly likely that no dividend will be paid. If it is, it will deplete capital further.

Look for companies that pay out less than 50% of their profits in dividends if you want to err on the side of safety. To calculate the percentage, just take the dividend and divide it by the profits. For example if a company makes $1.00 a share and pays a 25 cent dividend, then it's paying out 25% of its profits (25/100).

As for the those special industries like utilities and REIT's, they pay dividends well in excess of 50% of earnings, sometimes, in REIT's, more than earnings. That's because REIT's are required to pay out at least 90% of earnings to maintain their tax status. And it's Funds From Operations (FFO) that supplies the cash to pay the dividend, not earnings.

Some utilities are structured to pay out dividends to attract investors to continue to buy or hold the stock. They may pay out more than 50% of their profits, with the understanding that they won't be growing dramatically. Income investors would find these of interest. The keys to future payments is how stable the revenues have been over the last several years and if utility regulators have been willing to allow price hikes for the company.

One final thought: companies are loathe to cut dividends. They know many investors hold their stock because of the dividend. If it's cut, many investors will sell, driving down the stock price. Managements are reluctant to lower or eliminate dividends. However, any time they raise them, it suggests a confidence in future earnings and the continued ability to pay shareholders quarterly.

 Ted Allrich