Beware the Dividend Yield Trap
High Yield May Signal Problems
Companies that pay dividends can be wise investments, especially if you hold the stock over a long period.
When you add the dividend into any price appreciation, you can enjoy both current income and growth. Of course, you can reinvest dividends if you don't need the current income.
One way investors look for high dividend paying stocks is by using dividend yield as a guide. Dividend yield tells you what percentage the stock returns relative to its price.
Calculating Dividend Yield
Dividend yield tells you how much of a cash benefit you're getting from a particular investment.
For example, if a stock trades at $25 and the company's annual dividend is $1.50, the dividend yield is 6%, or $1.50 divided by $25.
Dividend Yield = annual dividend per share / stock's price per share
You can search for companies with high dividend yields by using a stock screening service such as Morningstar.com.
However, while you can get a list of companies with high dividend yields this way, you must not make investment decisions using just this one metric. Things are never that simple in investing!
Dividend Yield Trap
Dividend yield can lead you into a trap if you're not careful. The divisor of the formula for dividend yield is the stock's price per share. So if the price drops and the dividend remains the same, the dividend yield will rise.
You may buy a company with a high dividend yield, but one that is also on its way to the poorhouse and may not be able to afford to pay any dividend in the near future.
Consider what the other fundamentals look like. Dividends are paid out of cash and cash comes from earnings. Does the company have a healthy supply of cash and a consistent history of earnings and earnings growth?
If a company has just taken on a huge debt through an acquisition, for example, how is that going to be paid? Will it suck all the free cash out of the company?
Dividend yield is just one of many parameters you can examine through a stock screen like the one on Morningstar.com.
Set the screen to pick companies with a history of strong growth and earnings and a forecast of continued revenue growth—along with a high dividend yield—and you may have an investment candidate.
The Bottom Line
Companies with a high dividend yield may be great investments if the rest of their fundamentals also fall into line. Just be careful when one metric looks good and the rest are questionable. That's a sure sign not all is right with the company.
It's important to look at total annualized return over one year, three years, and 10 years as well because a high dividend won't compensate if the stock price is on a decline.