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Tickers in this Article: MXIM, WSM, DOW, TRA, PBCT, GE, PCL
Portfolio managers, arbitrageurs and regular investors add dividends to their portfolios to ensure that they receive a steady stream of cash flows despite market volatility. While such logic is supported through extensive analysis and financial modeling operations, not all high dividend paying shares serve as ideal investments. Firstly, dividends decrease the value of a stock by the amount of the payout - if a corporation is trading at $25 and announces a $1 dividend, if all other variables are held constant, the stock will depreciate to $24.00 on the ex-date. Basically, there is a tradeoff between capital gains and dividend income, although the two are taxed differently. Secondly, when a company experiences financial losses, sometimes it is in its best interest to cut dividends to preserve cash and undertake profitable capital expenditures. Finally, maintaining a high yield signifies that management is unable to effectively utilize funds toward expansion projects.

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It has been argued that people are often mesmerized with double digit yields, that arise when equity price fall. In this scenario, a high dividend yield arises merely due to poor performance results. Failing to reduce dividends during periods of economic loss hinders the long term growth and sustainability of the firm. (Although the analysis was written a year ago in the midst of the tumbling markets, Avoid the Dividend Trap makes a compelling argument to question the quality of dividends.)

Suspicious Dividends
Excessive payout ratios cannot be supported over a long term horizon and will impede the return on equity of the corporation. Maxim Integrated Products (Nasdaq:MXIM) and Dow Chemical Company (NYSE:DOW) currently have payout ratios of 296% and 282% respectively, while Williams-Sonoma (NYSE:WSM) carries a ratio of 4185%. These figures do not suggest that companies such as Williams are doomed for failure, but simply reflect that based on current operations, an ongoing dividend plan is unsustainable; either these firms will have to turn a profit in upcoming quarters, or cut their dividends. However, investors take dividend cuts as a negative indicator of future performance, which results in struggling firms often fighting the inevitable. Remember what happened to General Electric (NYSE:GE) when the company cut its dividend last year.

Companies can also refuse to cut their dividends when they are expecting to increase sales and earnings in upcoming periods. The financial sector, for example, has experienced major losses due to write downs, defaults and overall poor performance in the last two years. Those who anticipate a reversal from this trend in the industry would retain the current dividend policy. People's United Financial (Nasdaq:PBCT) cannot maintain an ongoing 205% payout ratio, but if earnings grow, then the metric would be reduced. The same type of reasoning can be applied to firms in other sectors, such as the agricultural giant Terra Industries (NYSE:TRA) which, like the other aforementioned companies, currently has an unsustainable dividend policy.

The Bottom Line
Dividends add value to a long term portfolio only when they can be upheld moving forward. Similar to an individual with excessive credit card debt who makes monthly payments that are outside his means, excessive cash payouts cannot be maintained. Rather than focusing on the ratio values presented in this article, investors should take note of the long term trend in the metric and its comparison to that of comparable companies. Since an investment decision cannot be based on a single number, further analysis must be conducted prior to buying or selling a stock, but a large payout ratio plays an important role nonetheless.

Trusts, like the Plum Creek Timber (NYSE:PCL), REIT are known to offer significant dividend payouts ratios. While PCL carries a 116% payout, this value is much more acceptable given the industry of the organization. When assessing an investment, reasons of concerns arise when the majority of earnings are consistently being spent on dividends rather than being reinvested into the firm. (For further reading, check out Dividend Facts You May Not Know and 6 Common Misconceptions About Dividends.)

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