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Total return from stocks comes two sources: price appreciation and dividends. Most investors focus on the former much, much more than the latter. And following the go-go days of the 1980's and 1990's, it's understandable why.
But for long-term investors, dividends are a very important part of the equation. Over the last 80 years for instance, they have contributed a whopping 44% of the total return of the S&P.
Dividends are the Point
What is the point of owning a company if you never receive any cash from it? Investing for price appreciation alone is nothing more than trading paper, where you hope someone will come along one day and pay you more than you paid.
But why does the market reward companies that grow their earnings with higher prices (at least over the long run)? Because higher earnings mean higher cash flow and more dividends at some point in the future, thereby warranting a higher stock price.
That's why it's important for dividend-paying firms to also retain a portion of its earnings to grow the business.
If Something Sounds Too Good to Be True...
Be leery of high-yielding stocks with poor underlying business fundamentals. That juicy dividend yield can seem alluring, but they can and often do wind up getting cut.
One important metric to consider when analyzing the sustainability of a company's dividend is its payout ratio. This is simply the percentage of net income a company pays out in dividends.
Or better yet, calculate the percentage of cash flow a company pays out in dividends.
If a company is consistently paying out more in dividends than it generates in cash, that should be a red flag to investors that the dividend may get cut. Especially if its debt levels are high. Because those payments will get sent out before the dividend checks do.
And if a company is paying out all of its earnings in dividends, it won't have anything left over to grow the business. It must then raise capital by issuing debt or additional shares to fund its growth. And that can be a dangerous game.
3 Big Yields Worth Considering
There are a some stocks out there with huge dividend yields that look sustainable. I've highlighted 3 below that currently yield more than 7.5%.
Neither has cut their dividend in the last 10 years and all were able to pay their dividends from operating cash flow in the last year. And each one is expected to see earnings growth in 2012.
(Note: the cash payout ratio is calculated as TTM Dividends Paid / TTM Operating Cash Flow)
Dividend Yield: 12.2%
Cash Payout Ratio: 57%
Dynex Capital is a real estate investment trust (REIT) that invests in mortgage assets on a leveraged basis. Its investment strategy targets higher credit quality, shorter duration investments in Agency MBS (mortgage backed securities) and non-Agency MBS. It was founded in 1987.
Mortgages? Leveraged? Sounds scary, but the company managed to grow its earnings throughout the Great Recession, and earnings are expected to grow 22% in 2012. And the company has increased its dividend twice since late 2010, with its operating cash flow comfortably covering its dividends.
Dividend Yield: 8.1%
Cash Payout Ratio: 39%
Windstream provides communications and technology solutions to customers in 29 states. The company has been focusing on growing its total business revenues and high-speed Internet revenues to offset declining landline revenues. Based on consensus estimates, analysts project 10% EPS growth for WIN in 2012.
Windstream generates strong cash flow which covers both its dividend and capital expenditures. It has paid a steady 25 cent per share quarterly dividend since late 2006.
Dividend Yield: 7.9%
Cash Payout Ratio: 91%
Boardwalk Pipeline Partners is a master limited partnership (MLP) focused on the transportation and storage of natural gas in the United States. Its interstate natural gas pipeline systems generates fee-based income that does not fluctuate with natural gas prices. This means strong and steady cash flow for the unitholders.
In fact, since it began paying a distribution in 2006, Boardwalk has raised it a remarkable 23 consecutive quarters, even throughout the Great Recession.
Although they often get overlooked, dividends are an important part of the total return equation. And these 3 stocks all offer very attractive yields.
Todd Bunton is the Growth & Income Stock Strategist for Zacks.com and Co-Editor with Steve Reitmeister of the Reitmeister Value Investor that snaps up discounted value stocks and sells them after the market realizes their true worth for long-term gains.
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