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Not all dividend stocks are the same and investors looking for income need to look at the first initial appearance. But they can give themselves the best chance by avoiding the important calculations.
Mistake 1: forgetting where the dividend comes from
It’s easy to feel rich when the dividend payments come. But investors should not forget that dividends are paid out of the company’s money.
For example, when Games Workshop (LSE:GAW) paid its investors a dividend last month, earning 85p per share. But the company they have equity in has released that money.
That means investors who consider themselves business owners — as Warren Buffett says they should — shouldn’t think they’re super rich. All they have done is to destroy part of the property they have.
Games Workshop has been an excellent investment of income. Its popularity Warhammer products have allowed it to increase its profits dramatically over time.
However, in each case, the firm’s cash flow decreases by the amount it distributes. So receiving a dividend doesn’t make investors rich – it just transfers cash from their holdings to their account.
Of course, investors can reinvest their profits to increase their ownership of the company. But they will have to pay Stamp Duty on it, which means they will get less in stock than they would have in cash.
Owning shares in Games Workshop has been a great way to build wealth over the past decade. But this is because its profits grew by more than 1,000%, not because it paid back investors.
Mistake 2: overemphasizing profit coverage
The dividend coverage ratio measures how much income a company pays out to investors. Strictly speaking, the formula is: (income – preferred dividends) ÷ dividends paid.
Investors often use this to try to gauge how sustainable a company’s distribution is. But it can be very misleading.
Over the past 10 years, Games Workshop has distributed more than 75% of its net income to shareholders. But the company’s low reinvestment requirements mean it can return most of its profits to investors.
That doesn’t mean the dividend is guaranteed – consumer spending in a recession is an ongoing business risk and this could limit distributions. But any money it makes can be distributed.
In contrast, the distribution of shareholders from The Pennon group they account for less than half of the company’s revenue. But it would be a mistake to think that this means that the dividend is less risky.
The water center has a lot of infrastructure to maintain and this requires a lot of money. As a result, there is a huge gap between the earnings it reports and what it can return to investors.
Therefore, investors should avoid thinking that looking at the dividend coverage ratio is the only way to understand how strong the dividend is. It can be a useful metric, but it can also be very misleading.
Warren Buffett
Both of the above mistakes are ones that Buffett has highlighted to investors. I Berkshire Hathaway The CEO touts the success of his company’s investment Coca-Cola for its growth, not its profit.
Equally, Buffett attributes the success of an apple up to the minimum capital requirements of the company. Diversified investors who follow these may not be able to manage the same returns, but they give themselves a much better chance.
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