Looking back at S&P 500 returns from 1926 – 2004, it’s estimated that dividends comprised 35% of total market price appreciation. Pretty substantial right? Wait, the case supporting dividends gets even stronger when you add in the impact of dividend reinvestment and compounding, which shows that dividends outstripped price appreciation by over 25 times.
Flash forward to 2009, and we see here that Standard & Poors is predicting that this year will witness the biggest drop in dividends since 1942. With all of these accidentally high dividend stocks, it is not surprising that many companies are slashing their dividend payouts to conserve cash.
With this recent rash of dividend cuts by historically dependable dividend-paying companies, income investors are finding it increasingly challenging to find safe high dividend yields.
One important metric in assessing the safety of a company’s dividend is free cash flow, or how much cash is left over after paying expenses and dividends.
A related figure is the dividend payout ratio, which usually gives investors a good idea of how much of a cash cushion a company has after paying out dividends. With the exception of MLP’s, LP’s, and REIT’s, beware of firms that pay out very high percentages of their earnings in dividends, or, even worse, borrow money to maintain dividends. (This doesn’t apply the same way for MLP’s, LP’s, and REIT’s, because they are obligated by law to pay out up to 90-95% of their income to shareholders, instead of paying income taxes). An important figure to monitor here is FFO, or Funds from Operations, which should at least be steady, if not always increasing.
A good example of a stock with a low dividend payout ratio is Olin Corp., (OLN), which, at a price of $14.65, is currently yielding an attractive 5.46%, and has a dividend payout ratio of just 39%.
One way you could gain even more yield out of this stock would be to sell covered calls options against it. As an example, using this strategy, you would buy a minimum of 100 shares at $14.65, and then sell the Jan. 2010 $15 calls against it for $2.30/share, which would give you an additional 15.7% yield.
Your total yield, (and downside protection), would then become 21.16%, for this 10-month investment term. This equates to an annualized yield of approximately 25.39%.