Great question from a faithful reader deserves a response this week. Please comment on why the dividend yield on some shares is so high? We noticed these high yields in the local paper - 16.34 percent and 18.73 percent. Are these for real? How can any company do this?

To answer this question, a brief overview of dividends is in order.

What is a dividend? Wickipedia says dividends are payments made by a corporation to its shareholder members. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend.

Dividend payout ratio. Many corporations need to retain a portion of their earnings and pay the remainder as a dividend utilising a payout ratio formula, (ratio of dividends to earnings), perhaps in a normal neighborhood range of 40 percent dividends and 60 percent retained for future planning. For example, if the company earns a profit for the year of a million dollars, the decision to be made by the Board of Directors and senior management are three-fold:

1. Should they declare a dividend at all? Regardless of the profit margin, they may not if they are scaling up expansion plans, retiring debt, facing an economic downturn or financial restructuring.

2. If they pay a dividend what should the payout ratio be? Let's say they opt for 35 percent dividend payout ratio, then $350,000 will be divided by the number of shares held by shareholders.

3. When they distribute the dividend, should it be in cash or in stock?

Generally, companies stay within a stable dividend payout ratio; however, possibly for confidence builders, companies may scale up those percentages, returning 80-100% or even more to the shareholders. The largest ratio I have ever seen was 110 percent of earnings in a dividend to Ford shareholders some years ago. This may seem great for the shareholder but worrying for the future health of the company.

No business can operate for long by spending all available cash; you are now at the beck and call of your bondholders and debt-holding bankers.

Dividend paying stocks have been around a long time, more than a hundred years in some companies including some in Bermuda. AT&T and Stanley Works paid dividends since around 1880. Have the companies paid dividends every year? Not always, but overall the consistency of payment with stocks such as Caterpillar, Exxon and so on is quite remarkable.

A dividend is allocated as a fixed dollar amount per common share (preferred shares are handled differently). Therefore, a shareholder receives a dividend in proportion to the number of shares that are currently owned. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one. Reinvested dividends, the process where cash dividends are automatically reinvested into additional shares, is not the same as receiving stock dividends which is a non-cash event

Dividend payments are fixed, generally, for the year unless there is a reason to issue a special dividend, a large one-time payment when earnings are going gorgeous, or reduce/discontinue payment - in the event of a severe economic event.

Microsoft made history with a massive special dividend some years ago, while Unisys got into financial difficulty and ceased dividends after a hundred year track record.

Dividend yield fluctuates inversely with the value of the underlying stock. The yield calculation is a simple math function. Divide the price of one share of stock into the annualised dividend payment - there is your yield - for that second only.

The yield will fluctuate in capital markets by the share value price of the day. Your actual yield on the shares that you own truly depends upon the price you paid originally for the shares and the current dividend payment. If you own the shares whether the share price in the market goes up or down, has no bearing on your cash payment or your yield. See chart.

Four ways to look at dividend yield. If you are in the market to purchase shares for dividend yield, that's another story.

Let's take a good stable financially strong company whose share price has fluctuated significantly of late. Simply due to systemic market conditions on a global basis. The cash dividend payment has remained the same and is indifferent to the share price. The result below and in chart:

1. Low share price, decent dividend cash payment, high yield - this can explain very high dividend yields in one scenario.

2. High share price, same decent dividend cash payment, low dividend yield.

3. The third situation that drives high dividend yields is a company that deliberately pays higher dividends to attract new investors into buying equity in the company.

These yields and these companies must be given real scrutiny before purchase..

4. Any time there are major changes in a company shares, dividend yield should be a secondary consideration. The primary driver of investment choices should always be the company's financial strength. Know without a doubt whether it is financially viable and cash solvent; otherwise, your high dividend yield is meaningless when the shares are close to worthless

Why pay a dividend at all? Good question, Warren Buffet has never done so, hence the enormous market value of one Class A share of Berkshire Hathaway stock.

One camp feels that paying dividends depletes company cash reserves. Stock dividends, while not generating cash, provide additional shares, which may dilute shareholder ownership.

Conversely, studies have been conducted that demonstrate dividend-paying companies are a good bet because paying dividends means they manage their cash flows.

Final worthy item. It has been said again and again. A dividend is not a God-given right, nor is it even guaranteed. What the Board of Directors and senior management giveth, they can just as easily take away. Often, Bermudians have informed me over the years that they had their investment plan all worked out: buy investment property to gather in that executive rent, while they occupy a tiny apartment and live off their local dividends. Yes, in theory, it was a great idea and it worked - then.

Now it is time to realise that there is a concentration of risk in one tiny country's economic structure. Think global: cash currency, stocks, bonds, and property.

Thus endeth the lessons on dividends.

Martha Harris Myron, CPA, CFP(US) TEP(UK) JP- Bermuda is an international Certified Financial Planner™ practitioner. She specialises in independent fee-only cross-border tax, estate, investment, and strategic retirement planning services for Bermuda residents with cross-border and multi-national connections, internationally mobile people and US citizens living abroad. For more information, contact martha.myrongmail.com or 735-4720.