20 Jul Why Dividend Cuts Mean Warning Bells for Value Stocks

Warren Buffet is probably best known for his strategy of value investing. Basically, the value investing technique calls for using financial metrics to determine the actual value of a stock and to check if it is currently undervalued. If that is the case, bargain hunters can buy out the stock as it is available for less than its intrinsic value.

But finding the intrinsic value of a stock can be tricky business. Financial experts use price-to-earnings ratios along with other metrics to measure value. However, with the volatility that affects the stock market today this becomes even more challenging. Let’s crack some stock market terminology to understand how to dividends can influence value investing.

Dividend cuts

A company who wants to build a good market reputation ensures that they pay regular dividends. While these on-dot payments should please shareholders, they can also have the opposite effect. Though investors are pleased that the company is issuing these dividends owing to a healthy profit, there are others who feel the funds should be reinvested as a growth strategy for the organisation.

In December 2015, several profitable companies cut down on their dividends. Taken to be value investments, both Kinder Morgan Inc. (NYSE: KMI) and Freeport-McMoRan Inc. (NYSE: FCX) have dropped dividends. Others like McMoRan have stopped paying dividends totally. Value investors, who take into account only certain financial ratios, should always check for a company’s current dividend structure.

As a rule of thumb, the best way to approach this is to compare a company’s dividend payout with a company’s total earnings. A good yardstick is at about 40% dividend payment. Ratios above or below need to be further examined.

Another important factor to consider for financial performance is debt. If a company pays dividends regularly but ignores its liabilities it should set off an alarm.

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