Dividends To Avoid

By Investopedia Staff | May 01, 2011 AAA

Sometimes investors are easily attracted to high dividend yields and they immediately add those stocks to compliment their income portfolios. The fallacy in such a strategy is that the full story behind the stock is often not explored. There could be many different reasons why some companies currently support substantial dividend yields, and these reasons must be analyzed prior to purchasing a stock.

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Exploring the Issue
The Coca-Cola Company (NYSE:KO), for example, has a solid streak of increasing earnings and dividends. It recently marked the 49th consecutive year in which the company's dividend was raised. With its current yield at 2.8% and regular strong yearly performances, Coke can serve both the needs of capital gains and steady dividend income.

On the other hand, other companies like Frontier Communication (NYSE:FTR) offer a very attractive yield of nearly 10%. However, some would consider this stock an "accidental high yielder." Year-to-date, the share price of has fallen by 15%. While this may present a buying opportunity for interested traders, the high dividend yield is basically artificially inflated due to the lower stock price. Despite that the dividend-per-share amount has declined in recent quarters, the diluted earnings per share value has fallen at a faster rate. Windstream Corporation (NASDAQ:WIN) falls under the same boat - share price has fallen while dividends remain stable.

Problem with Dividend Cutting
Because decreasing a stock's dividend will result in bearish sentiment toward the company, corporations will often attempt to maintain a regular policy as earnings are falling. When GE (NYSE:GE) lowered its dividend in 2009 for the first time since 1938, the stock price plummeted from $9.28 on February 26, 2009 to $6.75 by March 5, 2009. In order to avoid such losses, companies will often wait for better times and thus pay dividends which exceed their earnings. Unfortunately, such a policy is not sustainable.

High Dividend Payout Ratio
A dividend payout ratio which exceeds 100% indicates a situation in which the payout per share exceeds the earnings per share. Basically, the company is paying out more than it earned. While this type of situation is common when firms experience a poor quarterly performance, unless the operations of the firm improve, it will be forced to lower its payout eventually. GalaxoSmithKline (NYSE:GSK), Kinder Morgan Energy Partners (NYSE:KMP) and Simon Property Group (NYSE:SPG) are three well known companies that, based on recent quarterly reports, have an unsustainable long dividend policies ... unless performance improves.

Bottom Line
Every company that pays a dividend cannot be directly compared to Coca-Cola, ConocoPhillips (NYSE:COP) or AT&T (NYSE:T) simply based on the yield. Rather than just looking at the dividend value, investors must take other quantitative and qualitative factors into consideration to determine if the yield is sustainable.

Companies that have an unreasonable payout ratio may turn out to be a good investment if their situation improves. However, investors must look beyond just the dividend. (These five qualitative measures allow investors to draw conclusions about a corporation that are not apparent on the balance sheet. Check out Using Porter's 5 Forces To Analyze Stocks.)

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