When it comes to investing, the purpose is to receive the biggest reward possible given the prevailing circumstances at the time an investor decides to cash out. Generally, when investing, investors can take two approaches: buy a stock that guarantees periodic dividend payments or simply invest in a stock that promises a massive payout in the future in the form of capital gains.
Statistically, stocks that tend to pay dividends consistently do not return as a much as a company that focuses on reinvesting earnings for purposes of sustaining business growth. However, this does not mean that these kinds of stocks cannot yield returns when an investor decides to cash out. But the decision is often a tough one for most investors as they consider ruling out further periodic payments in favor of a lump sum payment.
When an investor eventually decides to cash out, he/she is essentially selling the opportunity to receive future dividend payments in favor of an immediate lump sum payment. With that in mind, the time value of the money factor comes into play, which means investors may receive less than they would have received for holding the stock in perpetuity.
The application is similar to what insurance companies and policyholders do. For instance, an accident/temporary disability cover promises to make periodic payments to policyholders for the time they are not able to engage in gainful employment.
These forms of payment are referred to as structured settlements, but the policyholder can also choose to receive a lump sum rather than the annuity payments. This is when you hear of people selling structured settlements in the insurance industry. There are companies that specialize in facilitating these kinds of transactions.
Nonetheless, there is a slight difference between this kind of settlement and dividend stocks. With stocks, the periodic dividends are paid in perpetuity, but they are not certain while in structured settlements, the periodic payments are known, and the length of the period may be predetermined in most cases.
In the stock market, the best time to pull the plug is probably when you realize that the company’s cash flow stability may be coming into question. The best way to identify this is by looking at the current ratio, profitability margins and the prevailing debt load in comparison to total cash.
If the profitability margins are squeezing and the current ratio is falling, then this is probably a good sign to pull out of your investment and say goodbye to the periodic dividends. Declining cash flows in comparison to an increasing debt load may also be a good sign that the company may not be able to sustain its current dividend rate in the near term.
For instance, former dividend kings in the oil and gas industry may not be as attractive as they used to be due to the recent decline in oil prices. BP PLC (BP, Financial) reported a loss of $2.49 per share in the last 12 months but still pays a dividend of $2.40 per share at a current yield of about 7%.
However, when you look at the company’s activity on the balance sheet, you will realize that it recently increased its debt load by nearly $5 billion. This makes it a high-risk dividend stock so if you already had a position in the stock and feel that the current market price may offer a decent return on investment, then it might be the right time to pull the plug.
In addition, an investor may choose to cash out his/her investment in a dividend stock based on circumstances. Say for instance there is an urgent need that requires you to spend more money than you have in your bank account. Cashing out on your dividend investments may be more viable than selling the stock that promises high returns in the form of capital gains in the near future.
This is because you may only forego your dividends for a few quarters before reinvesting in the stock in the near future. Under these circumstances, you may also not have to pay a higher premium on the previous price of the stock. On the contrary, a growth stock is likely to have rallied significantly by the time you decide to reinvest in it.
For instance, Netflix (NFLX, Financial), which has been a growth stock for the last four years, nearly doubled its valuation between December 2014 and April 2016 after rallying from $54 per share to Thursday's level of $104.45 per share.
At some point, shares of Netflix traded at a price of $130 per share. On the other hand, shares of Johnson & Johnson (JNJ, Financial), which has been one of the best dividend-paying stocks over the last 15 years, reported a meager increase in stock price from $108 per share to Thursday's level of $109.27 per share during the same period.
As such, it would have been easier to cash out your investment in the dividend-paying Johnson & Johnson rather than the growth-driven Netflix if your plan was to return and reinvest in the stock after dealing with your emergency.
Conclusion
The bottom line is that, at times, the decision to pull out your investment in a structured settlement payment plan or a dividend stock may be beyond your control. However, when you are faced with the challenge of making the choice, a risk-reward analysis may come in handy.
