Yields on bonds have fallen in recent years and have remained low for some time. So what is to be done if you're accustomed to receiving interest through bank accounts, certificates of deposits (CDs) or bonds? Income-seeking investors have started searching for income-producing alternatives. This trend has influenced many investors to take on riskier investments to replace today’s disappointing bond market yields and it has even led some savers to consider alternatives in an attempt to replace the interest they may have received in years prior. One of those alternatives is high-yielding dividend paying stocks.
An Example of a Dividend Stock
Let’s examine a real company that fits this profile, but we’ll call it Company A. With a current yield of 4%, it appears attractive in today’s market. An income-hungry and well-versed investor notes that the yield has increased over the last four years. So what does this mean? (For related reading, see: Where Do Investment Returns Come From?)
Yield is calculated using the per-share annual dividend and the stock price of a company. Therefore, a stock’s “yield” is heavily dependent on both these factors and both must be considered when evaluating the investment opportunity. Below is a chart showing Company A’s stock price compared to its dividend yield from 2007 - 2014.
We see that the price of the stock and the dividend yield move conversely. The recent increase in yield may have been caused by the dramatic decline in the price of the stock. But the chart above demonstrates how the yield only tells part of the story. The rest of the story unfolds when we look at the growth of dividend per share.
In the above chart, we see the historical growth of Company A’s dividends. Between 2007 and 2011, the payout increased from 12.5 cents to 17.5 cents per share. This company did not cut the dividend during the sharp price decline in 2011, which may indicate that the company expects to be able to endure the downturn. (For more, see: Don’t Buy What You Don’t Understand.)
The chart also shows that, since 2012, both the dividend and the stock price have remained stagnant. This stagnation and the weakness of the stock price should cause an investor to dig deeper into the financial strength of the company before investing, to determine whether the dividend payout is sustainable. Investing in a stock solely to get the advantage of the dividend can be dangerous. It is important to understand that you will also be invested in the equity of the company. A review of the financial statements should provide information about whether the company can afford to continue the dividend payout and if corporate performance is on the right track.
The Bottom Line
So when screening for high yield, don’t stop at yield – strive to understand why it’s high.
Reaching for yield in dividend-paying stocks can be an enticing alternative for income. However, a dramatic decrease in a stock’s price may result in an inflated yield and misrepresentation of a good investment. Further analysis to determine if the company’s cash flow is under pressure or distressed may make a difference in the investment decision. Taking the time to evaluate these factors is worthwhile before deciding whether to place a trade. (For related reading, see: Why You Should Diversify and Rebalance.)