5 Facts You Didn't Know About Dividends

By Asit Sharma Markets Fool.com

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Certain investors don't need to be reminded that despite their conceptual simplicity, dividends as an investment tool continue to reward as much study and research as one is able to commit. As we dive into a new year, below are five interesting facts about dividends you probably don't already know -- with a few investing tips sprinkled in.

1. An entire branch of stock valuation theory is devoted to dividends

Known as the Dividend Valuation Model (DVM), this theory is based on the premise that a stock's value is equal to the sum of all future cash flows to investors, discounted back to today's dollars at an appropriate rate.

This concept is commonly expressed in a calculation known as the Gordon Model, which assumes that the annual dividends a company pays shareholders will expand at a constant rate indefinitely.

Additional models account for the fact that dividend increases are rarely linear, and also for the caveat that most companies experience distinct phases of growth, in which the amount of dividends paid to shareholders can vary greatly.

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The gist of all DVM variants is simple: What investors are willing to pay for a stock often has a great deal to do with the underlying company's ability to consistently increase operating cash -- and return some of that cash to shareholders on a regular basis.

2. More than 10% of dividend-paying companies in the S&P 500 are in the red zone on an important metric

You're probably familiar with the payout ratio, that is, issued dividends divided by net income: a measure of a corporation's capacity to pay dividends to shareholders out of annual earnings. As a general benchmark, payout ratios below 50% are thought to be relatively safe. Conversely, payout ratios too much above 50% can provide a warning signal to investors, as potentially too much cash is being sent to shareholders at the expense of reinvestment in the business. Payout ratios approaching or exceeding 100%, with a few exceptions, often reveal an unsustainable dividend-payment stream.

According to a recent research report by FactSet Insight, for the twelve-month period ending in the third quarter of 2016 (i.e. Sept. 30), fully 44 of 419 dividend-paying companies in the S&P 500 Index sported payout ratios above 100%. This marks the second-highest number of S&P 500 companies breaching a 100% payout ratio in the last ten years -- the highest number occurred in the first quarter of 2016.

Are you investing in leading U.S.-based, large-capitalization stocks? These numbers suggest that collecting dividends from blue chips doesn't in itself ensure income safety: Be sure to check those payout ratios.

3. The dividend yield of the S&P 500 is declining

According to the same FactSet research report, the average yield among dividend-paying companies in the S&P 500 has actually been declining recently. S&P 500 yield has dropped 11.3% over the trailing twelve months ending in Q3 2016, to 1.98%.

This trend is partly the result of rising stock prices. During the period in question, the S&P 500 Index rose nearly 13%. But the aggregate dollar amount of dividend increases among member corporations issuing dividend checks only rose by $430.9 billion (only!), or 4.8%. So naturally, when prices outstrip dividend hikes, yields drop.

Yields may decline further in 2017. The FactSet study noted that aggregate dividends per share (DPS) of the S&P 500 have risen 4.2% over the year covered in the report, which is slower than the year before, and in fact marks the fourth straight twelve-month decline in DPS growth rate.

4. A simple trick increases the clarity of the payout ratio

While we're on the subject of dividend yields and payout ratios, let's look at the concept of "dividend coverage." This is a term for the number of times that net income, or another chosen measure of financial returns, will "cover" a company's annual dividend payout.

An investor can run any number of metrics based on this concept. My personal favorite is to divide free cash flow (minus any preferred dividends) by common dividends paid to shareholders. This tells me how many times free cash flow can cover the expected common dividend.

But you don't have to be so detailed. For a ballpark indicator of dividend health, simply divide 1.0 by a company's payout ratio. This returns the number of times net income will cover a dividend payment. Generally speaking, you're looking for a result of 2.0 or higher.

For example, if a company has a dividend payout ratio of 75%, divide 1.0 by 0.75. The result, 1.33, means that the company's trailing twelve-month earnings will provide for the annualized payment of the most recently declared quarterly dividend, but without much breathing room to speak of.

Since this earnings version of dividend coverage is simply the inverse of the payout ratio, you're essentially looking at the payout ratio from another angle, to help you more clearly assess its implications.

5. You can buy an ETF which tracks a version of "Dividend Aristocrats" for smaller companies

The ProShares Russell 2000 Dividend Growers ETF (NYSEMKT: SMDV) holds shares of stocks in the Russell 2000 Index which have increased their dividends for 10 years or longer. The strategy is akin to ETFs which track "Dividend Aristocrats," S&P 500 Index companies which have increased dividends for 25 years or more consecutively. But this ETF invests in smaller-cap companies which offer the potential for higher growth, in addition to the promise of stable and increasing dividends.

The fund seeks to replicate the performance of the Russell 2000 Dividend Growers Index. It boasts an efficient net expense ratio of 0.40, generates a handsome dividend yield of 2.4%, and has booked price appreciation of 36.8% on a total return basis since its inception on Feb. 3, 2015. This easily outpaces the total return of both the S&P 500 Index (15.1%) and the Russell 2000 Index (16.9%) over the same period. If you're looking to amplify your dividend knowledge in 2017, researching the Dividend Growers ETF may prove an auspicious way to begin.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems. The Motley Fool has a disclosure policy.