The Third Rule of Dividend Investing

By Floyd Saunders, The Author of Five Paths To Wealth, Family Financial Freedom and Figuring Out Wall Street.

Disclaimer:

Really Simple Investing make this information available for informational and educational purposes only. Really Simple Investing does not warrant the accuracy or completeness of the materials provided, either expressly or impliedly, and expressly disclaims any warranties for a particular purpose.

Decisions based on information contained on this site are the sole responsibility of the reader.

“The secret of sound investment in 3 words; margin of safety”

– Benjamin Graham

The third rule of dividend invest is safety. Or more correctly, insure you have a margin of safety in the price you pay for a stock.

If a business is paying out all its income as dividends, it has no margin of safety. When a business downturn occurs, the dividend must be reduced. It therefore makes sense to invest in businesses that are not paying out nearly all of their earnings as dividends.

The payout ratio (the lower the better) is a key component of a decision to buy any stock.

High yield low payout ratio stocks outperformed high yield high payout ratio stocks by 8.2% per year from 1990 to 2006.

The margin of safety is the difference between the amount of expected profitability and the break-even point. The margin of safety formula is equal to current sales minus the breakeven point, divided by current sales.

Anyone can obtain these numbers by reviewing a current financial statement of any publicly traded company. But there is a simpler way, intrinsic value. Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset.

The Dividend Value Builder website includes the analyze of an intrinsic value range for most of the quality stocks that are known as dividend aristocrats (Stocks with a 25+ year history of paying out increasing dividends). Simply subtract 20 to 25% from the intrinsic value to get to a margin of safety.

It’s important to have at least a 10% margin of safety, from a stocks intrinsic value when buying shares. This becomes a little less important when buying shares monthly, as dollar cost averaging will reduce you overall purchase price in most cases.

Benjamin Graham is the father of value investing. His strategy was focused on purchasing securities where the price was much lower than the total liquidation value of the corporation. This concept of purchasing stocks with a margin of safety has made investors billions of dollars in profits.

Dividend investing is a form of value investing, where investors do not realize all of their return all at once, but rather on regular and consistent intervals. Dividends provide a direct link between the financial performance of a company, and the returns of its shareholders. Sometimes the market does not recognize that certain firms are more valuable for extended periods of time, even if their earnings are higher and valuations are cheap. With dividends, value investors realize a return that puts them closer to realizing the intrinsic value of the stock, no matter what the market or the stock price does.

investors should analyze whether the dividend payment is sustainable. There has to be an adequate margin of safety in dividend coverage from earnings, which would ensure prompt payment of distributions if there was a temporary downturn in a company operations.

When a company pays out almost all of its earnings as dividends, that leaves little room for maneuvering if earnings decline. In addition, this leaves little for investing and growing the business. There are some exceptions, Real Estate Investment Trusts, Master Limited Partnerships to name a few.