On the surface, it seems obvious that chasing big dividends is smart trading. But in practice, a double-digit dividend stock may also be a red flag.
Because dividend yield is based on the dividend per share and current price per share, if the price plummets, the yield goes up. A high dividend could result from bigger problems in the fundamentals.
For evaluating dividend yield, what is the underlying cause of the decline? If you chase big dividend yield as the only test of investing or trading a stock, be prepared for possible price decline and the potential for severe problems. Those big yields exist for a good reason. It is smart to know that reason before buying shares.
To overcome this problem, don’t look only at the current dividend yield. Look at the 10-year record of dividend increases and review what has been going on in other key fundamental indicators: revenue and earnings, P/E ratio, and debt-to-equity ratio. These tell the bigger story. Also check current news about a company. If they have announced plans to file bankruptcy, the stock price may have fallen in recent days, and one result is a larger dividend. But it is not good news for stockholders, so be careful. Don’t rely just on the yield.
In evaluating dividends, there are three tests worth performing. First is the yield, but rather than looking only at current yield, check the trend over many years. Has the yield been rising, flat or falling?
Second, review dividends per share paid over many years as well. Companies whose dividend has increased every year but the last 10 years or more are referred to as “dividend achievers,” and this is a strong test of profitability and cash flow as well.
Third is the payout ratio, which is the percentage of earnings paid in dividends each year. It’s not realistic to expect this to rise indefinitely, but a steady ratio is a promising sign. A falling ratio could signal trouble.
In conjunction with trends in dividend yield, dividend per share and payout ratio, also track the debt-to-equity ratio for the same period. Is the debt rising, falling or remaining the same? If a company is increasing its dividends but financing payments with growing long-term debt, that is a troubling signal and a negative sign for stockholders. As a matter of cash management and profitability, a healthy dividend should be based on rising profits and careful management between earnings paid as dividends and earnings used for other reasons (buying and retiring stock, financing expansion, retiring debt, to name a few examples).
Some companies have been known to take on larger long-term debt to afford higher dividends, even in years of net losses. This may be an irresponsible move because higher debt means higher debt service in the future. However, there are no rules against accumulating more long-term debt. Those who rely on less effective tests like the current ratio could miss the significance of higher long-term debt (which does not show up in the current ratio) and what it means for stockholders over many years.
Dividends are important elements in stock selection, and a higher than average yield is desirable. Just be sure you know why the yield has risen before investing.