Dividends are payments that many companies make to their shareholders from their profits. For value stock investors, who seek to buy undervalued stocks that offer steady returns, dividends are an important factor to consider.
One of the most common ways to measure the attractiveness of a dividend-paying stock is to look at its dividend yield. The dividend yield, expressed as a percentage, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. For example, if a company pays $1 in annual dividends and its stock price is $20, its dividend yield is 5%. This means that for every $100 you invest in this stock, you will receive $5 in dividends.
However, the dividend yield is not a static number. It can change over time either in response to market fluctuations or as a result of dividend increases or decreases by the issuing company. That's why it's important to consider not only the dividend yield but also the past history of dividends and dividends growth rate. A company that has a consistent track record of paying and increasing dividends may be more reliable and stable than one that has a high but erratic dividend history. A decrease in dividends is not always a negative sign, as it may indicate a higher priority use of free funds, for example, for investments in R&D, M&A, share buyback etc.
Another concept that value investors should understand is the payout ratio or dividend payout ratio. This ratio shows the percentage of a company's earnings paid out as dividends from earnings retained to shareholders. For example, if a company earns $2 per share and pays $1 in dividends, its payout ratio is 50%. This means that the company distributes half of its earnings to shareholders and reinvests the other half in its business.
The payout ratio can help you assess how sustainable and flexible a company's dividend policy is. A low payout ratio indicates that the company has plenty of room to increase its dividends in the future or to cope with earnings fluctuations without cutting its dividends. A high payout ratio indicates that the company is paying out most or all of its earnings as dividends, which may limit its ability to grow or maintain its dividends in the face of challenges. Sometimes companies may pay dividends in excess of earnings for the current period, using cash from previous years. Having a large retained earnings balance allows a company to pay consistent dividends with no negative surprises and keeping its dividend payments history on a stable level. Nevertheless, in rare cases, the payment of dividends in excess of earnings may come from the cash received from the sale of the company's assets and property. In this case, the payment of dividends acts as a bad sign of withdrawing money for the benefit of major shareholders or management.