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Absolutely no one expected Citigroup, the $200 billion banking giant, to announce a sudden and deep dividend cut in 2008. Only one analyst, Meredith Whitney, warned about the underlying risks in the bank’s assets at the time. She was openly criticized by her peers for her analysis, but in hindsight we know she turned out to be right.

Citigroup, of course, wasn’t the only bank suffering at the time. Stock prices had plunged so dramatically that many banks were paying out double digit dividend yields in 2008. Bank of America’s dividend yield at the time was 10%. An income seeking investors who bought at that price, driven by the attractive yield, would have seen the next dividend cut by 98% by 2009.

The lesson is clear – dividend yields aren’t everything.
What is a high yield?

In theory, any yield higher than the yield on a government treasury is good. A dividend paying stock will not only send you regular cash, but also allow you to share in the company’s growing value over time. If the stock price moves up and the dividend grows along with it, you’ve probably made an excellent investment.

Dividend yields vary, but a ‘high’ dividend yield is usually higher than both the 10-year US treasury bond and the average dividend yield of the S&P 500. As of this writing, the 10-year bond yields 2.23% and the S&P 500 yields 1.87%. Meanwhile, Vodafone (VOD) offers a dividend yield of 5.12%.

However, the dividend yield isn’t the full story. Serious, long-term investors need to dig deeper to find out if the dividend and the stock price is sustainable. This means judging the health of the company.

Judging a dividend

Dividends are linked to profits, so the only way to figure out if a dividend is healthy is to run a quick dividend health check on the company’s balance sheet.

Pay close attention to the following factors:

  1. The dividend payout ratio: The amount of money paid out in dividends as a percentage of total earnings is a key metric. You need to know if the company has enough of head room to keep paying the sort of dividends it is. A high payout ratio leaves little wriggle room for the company and a sudden change in earnings will have an impact on how much you get paid. Meanwhile, a low payout ratio could mean the company isn’t handing out as much cash as it can afford to and the dividend rate could be due for an increase soon.
  2. The potential for earnings growth: Dividends are linked to earnings so keep an eye out for signs of earnings growth. A bright future usually translates to better profits and a fatter paycheck for investors who are willing to be patient.
  3. The level of debt: Warren Buffett once said that the only way for a smart person to go broke is by borrowing too much. Debt is a double-edged sword, so a small manageable amount might help the company increase its overall return on equity, debt can kill profits in a downturn if it’s too large. Keep a close eye on the debt-to-equity ratio. If there’s too much debt, the company is too risky for an income seeking investor.
  4. The amount of free cash flow: Although dividends are linked to earnings, the correlation isn’t direct. Companies may need to reinvest a certain amount of the earnings to keep the business running. The management may also decide to keep back a portion of earnings to fuel growth and acquisitions in the future. Dividends are usually paid out after all these investment requirements are met and there’s free cash flow left over. Check for a high free cash flow-to-dividends or the dividend coverage ratio to make sure the dividends are adequately covered.
  5. Management policies: What do Berkshire Hathaway and Google have in common? They’re both massively profitable businesses with way too much cash on the books, but they don’t pay a dividend. Both companies are uniquely managed by leaders who simply do not believe in paying out a dividend, so these high-quality stocks yield nothing. Apple under Steve Jobs also never paid a dividend. So, pay close attention to the management style and policy on dividends before you make an investment decision.

Each of these five factors has an impact on the future of the dividend.

To sum up

The dividend yield is a simple number that tells you how much income a stock will produce per dollar of investment. However, this number doesn’t tell the full story and serious income seeking investors need to dig deeper to find out if the high dividend yield is actually sustainable over the long-term. If you find a stock with a relatively high yield, make sure the management policy, debt, coverage ratio, and earnings potential all support it.

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