Education: Growth & Income Investing

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The Risk of High Dividend Yields

We made it very clear in our article “The Power of Dividends” that an investor’s total return can grow handily over the years when a dividend is factored in—especially a large dividend. But contrary to what one may think, bigger is not always better when it comes to a company’s dividend yield.

Dividend Yield Defined

A company’s dividend yield is defined as how much it pays out in dividends each year relative to its share price. The ratio is computed as follows:

Dividend Yield = Annual Dividends per Share/Price per Share

The calculation is fairly straightforward. The same should be said when a growth and income investor must choose between two dividend-paying companies, right? Consider the following two fictitious companies:

Kenny Roger's Roasters: 1.4%

Mario's Pizza: 5.5%

With Mario’s Pizza yielding 5.5%, I believe investors seeking income would automatically gravitate towards this particular company. But if things were that simple, we would all be making the big bucks. Unfortunately, life is not that clear cut for those who participate in the stock market. The above table represents a potential yield trap that investors can find themselves stuck in. Let me explain.

Don’t Get Trapped

By examining the formula presented above, one will notice that a company’s annual dividends per share are divided by its stock price. Does this make you think twice about automatically selecting Mario’s Pizza? It should.

What if I were to tell you that while Mario’s has continued to pay out the same quarterly dividend, its stock price has suffered as of late? The company’s stock was trading for $75 per share at the end of year one. It paid an annual dividend of $3.25 per common share of stock. Running the numbers, this would equate to a dividend yield of 4.3%.

Let’s fast forward a year later. The price of the company’s stock when year two wrapped up was $59 per share. However, the company still managed to pay an annual dividend of $3.25. What was once a dividend yield of 4.3% is now a 5.5% dividend yield (represented in the table above). But, as we have showed, this yield is quite misleading. It has grown at the expense of Mario’s stock price.

On the other hand, while Kenny Roger’s Roasters is currently yielding a “mere” 1.4%, it has experienced quite the opposite over the past two years. Not only has its share price grown, but it has also boosted its dividend policy. At the end of year one, the company was trading at $50 per share with an annual dividend of 50 cents per share (dividend yield of 1.0%). At the end of year two, Kenny Roger’s Roasters was trading at $55 per share with an annual dividend of 75 cents per share (dividend yield of 1.4% displayed in the table above).

Popping the Hood

For those who utilize a stock screen only to locate stocks with high dividend yields, and then purchase without any further investigation, this can definitely bite one in the butt. Before throwing your hard-earned money into a stock simply because its yield is extremely appealing, additional research must be conducted.

As we showed earlier, if one were to purchase on yield alone, they could be purchasing a stock that has plummeted in price as of late. A company with solid fundamentals should not see its stock price drop dramatically year after year. One should place close attention to a company’s earnings growth, management/leadership, products and services and its competitive strategy.

For growth and income investors seeking a healthy cash flow in the form of a dividend, dividend yield should only be one of few parameters used in a stock screen. It is highly recommended that the Zacks Rank, which takes earnings estimate revisions and earnings per share surprises into consideration, be added. Earnings estimate revisions are the most powerful forces impacting stock prices (Learn more about the Zacks Rank).