When Dividends Go Wrong

stocks

Investing a high yielding, conservative dividend stock is popular for many investors. There’s relatively lower risk implied with these kinds of stocks and having a steady income payment helps balance out annual returns. Combine this with a stock that’s expected to rise in value and you have the ingredients for a winning investment choice.

Considering that the yield on the 10-year treasury is at 2.26 percent, chasing higher yields can be very satisfying. But there’s an inherent flaw to thinking “bigger is better” – the company also needs to be able to deliver. Stocks with yields in excess of the average need to be viewed with some healthy skepticism. Too many times investors have learned the hard way – if it looks too good to be true, it probably is.

Spotting the weak one in the herd

Finding a solid stock with upside potential that also pays a dividend yield in excess of the 10-year treasury is only the first step. Before you jump aboard, you need to take a look at another critical measurement known as the dividend payout ratio.

The dividend payout ratio is the amount of dividends payed out to stockholders relative to a company’s total net income. That means if a stock has a payout ratio of 100 percent, the company is literally paying out of its income in dividends. There’s no money left over for capital investment or acquisitions unless a loan is taken out.

When a company crosses over the threshold and begins to pay out more in dividends than it makes, it’s a recipe for disaster. Unless the company can grow its way out of the problem quickly, the only other option is to cut the dividend. Once a company announces a cut, the stock takes an immediate and often precipitous dive.

Remember that a company’s first priority should be to grow and prosper. If a company is paying out large amounts of income in dividends, it could mean that the company doesn’t see many opportunities for growth. Even if its capable of paying out the dividend, investors should be especially wary of stagnant stocks that don’t seem to have anything going on – no new mergers or acquisitions and no new projects or products. Growth is everything on Wall Street and stocks may try covering up poor growth prospects with high dividend yields to keep investors happy.

 

Not all stocks with high dividends and high payout ratios are bad. Certain industries, like utilities, often have high payout ratios and debt levels, but aren’t necessarily in financial trouble. The stability of the industry and type of business means there isn’t a lot of volatility that could affect a stock.

While some business models are well-suited for high dividend payout ratios, it’s a reasonable strategy to simply avoid stocks that are paying out more in dividends than earning in income. A hefty dividend yield might just be masking a larger problem.