2 Things Investors Don’t Want in a Dividend Stock (Plus 1 Controversial One)
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There is a lot of information on the web that covers how to select stocks, even dividend stocks. In this post I am going to take the negative angle and present what I feel to be three things that I, as a dividend investor, do not want to see in a dividend stock. In my view, if any of my own dividend stocks exhibit any of these traits then that is a red flag which I need to consider acting on.[ad#tdg-embedded]
1. A Very High Dividend Yield
This one is talked about a lot and it has everything to do with risk. Among other things, a dividend yield is a statement of that company’s individual stock risk. The higher the dividend yield, the higher the risk – typically. I say typically because it is not as simple as looking at a company with a 7% dividend yield and saying that it is more risky. Instead, the investor needs to evaluate that yield against the own company’s historical yield patters. If the company has paid a dividend in the range of 6 – 8% over the past 5 years than the 7% is not out of the norm. However, if the yield is normally 3% for that stock and it is now 7% then something is going on with that company and you better figure out what it is.
2. A High Payout Ratio
First, let’s define what the payout ratio is (source: Investopedia)
The percentage of earnings paid to shareholders in dividends. The payout ratio provides an idea of how well earnings support the dividend payments.
A high payout ratio can spell trouble for that company. Again, this payout ratio must be looked into with consideration given to what the average historical payout ratio for that dividend paying company is.
Typically, a high payout ratio is considered to be in the neighborhood of 60% or higher. Since we are talking about ensuring that the company’s earnings can cover the dividend payment, it makes sense that a company that is paying a high portion of those earnings in dividends can become risky. Especially if that payout ratio has spiked recently. The last thing we want as dividend investors is to own a company that can no longer cover its dividend payments!
3. A Dividend Yield Less than the Market’s Yield
This one will be a bit controversial so I invite readers to chime in using the comments section below.
What I am getting at here is that when you go to buy a dividend stock, then perhaps it does not make sense to buy one with a dividend yield less than the overall markets? Why not simply go out and buy an S&P 500 index fund and get the higher dividend yield right off the bat and cut out your individual stock risk?
As dividend investors who buy individual stocks, we are taking on a higher degree of risks as we are exposed to what is called individual stock risk. Amongst the risks we get from the overall market, economic circumstances, and other factors, we also get the risk of that individual company performing poorly and taking our share price down. As such, it stands to reason that we should be compensated for this risk. One way is to receive a good dividend payment from that company. The higher the dividend payment the better (within reason – see above) to help offset that risk we take.
As of this writing, the SPDR S&P 500 ETF (NYSE:SPY) index is trading at a dividend yield of 2.6%. That would mean that as a dividend investor who believed in this rule you would avoid buying dividend stocks with a a yield less than 2.6%.
Summary
The first two things dividend investors don’t want to see in their dividend stocks are pretty common – a dividend yield that is too high and a payout ratio the company cannot afford. The third – a stock with a yield less than the market – is more controversial in nature and I am not totally sure where I stand on this one yet. I have not done enough research to determine it Perhaps over the long term a company with a higher dividend growth rate will help offset the lower yields. Let me know what you think using the comments.
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15 Comments on this post
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luciyahelan said:
As dividend investors who buy individual stocks, we are taking on a higher degree of risks as we are exposed to what is called individual stock risk. Amongst the risks we get from the overall market, economic circumstances, and other factors, we also get the risk of that individual company performing poorly and taking our share price down. As such, it stands to reason that we should be compensated for this risk. One way is to receive a good dividend payment from that company. The higher the dividend payment the better (within reason – see above) to help offset that risk we take.
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Stocks ResevoirJune 23rd, 2010 at 9:29 pm -
Financial Cents said:
Very well said!
June 24th, 2010 at 3:58 pm -
nak0807 said:
buying a lower than market-average dividend is appropriate if you believe the dividend will rise out of proportion to the valuation of the stock, or that the valuation will rise quickly and take the dividend with it. An important metric for dividend investing is yield-on-cost, inflation adjusted. Following yield on cost will expose the effects of both scenarios. Either way, your cash flow increases, and the value of the portfolio is determined by the cash flow it can generate.
June 27th, 2010 at 9:31 am -
Dylantheblogger said:
I think there is something that is being left out in this discussion, namely dividend growth. I realize that not all dividend investing is about dividend growth, however I believe this is a missing variable in the discussion. I agree that dividends can be a way of offsetting risk and generally there will be more risk in owning a few stocks than a whole index. The area where I disagree is that buying a lower yeilding stock provides no benefit over buying the higher paying index as a whole.
Allow me to demonstrate. For simplicity I will use the following assumptions. S&P 500 dividend yield is 2.5% growth is 5%. Stock has yield of 2% growth of 10%. Again for simplicity assume dividends are taken in cash. let’s look at the breakdown of yeilding on cost by year.
year 1 yields SP5 2.5% Stock 2%
year 2 yields SP5 2.62% Stock 2.20%
year 3 yields SP5 2.75% Stock 2.42%
year 4 yields SP5 2.89% Stock 2.66%
year 5 yields SP5 3.04% Stock 2.93%
year 6 yields SP5 3.19% Stock 3.22%Given yields are yield on cost. After 6 years the YOC is higher on the stock than the S and P. This means your investment in the stock is throwing off more cash each year than your S and P investment of the same initial amount. To see great examples of this look at the DividendsValue stock analyses NPV MMA calculations. There the premise is why would you take the risk and invest in a dividend stock if you could get more from an ultra low risk investment like a money market account.
Just my two cents.
June 27th, 2010 at 1:45 pm -
Leo J. said:
Do the factors listed apply to REITs (real estate, gas and oil, etc)?
It seems that there should be another set of metrics to evaluate them.Thanx,
L.J.
June 28th, 2010 at 10:50 am -
Helmut S Lenko said:
I have been a very successful property investor here in Canada since 1972. With inflation running in a range of 2 to 3% annually, how can
“survive” on 2.3% dividends? That’s a crappy return….
I went for long-term “holds” in real estate, and the results have been nothing short of phenomenal! From $80,000 to over $1million for a lakefront lot at Whistler, B.C., the site of the 2010 Winter Olympics; nice tax writeoff as well…June 28th, 2010 at 12:32 pm -
Dom Brunone said:
I think your last point is a good one that is not frequently mentioned. As you say, it has its limitations though, one of which you point out is dividend growth. If a company’s earnings are growing and its business model is such that it is likely to keep growing, then I don’t mind the lower yield. The yield may be lower because management has better things to do with its money than to pay it out in dividends. It also may be lower because others have caught onto the stock and bid up the price. But we better be very sure of that. One good example is Abbot Laboratories. Plunge the historical record and you will find that back in the 1980′s there were times that its yield was below the S&P500. Yet its dividend growth has been phenomenal.
July 1st, 2010 at 12:18 am -
Editor @ Double My Net Worth said:
These are three very valid points to watch out for. I particularly agree with the dividend yield versus the market. Personally, I prefer higher yields, that are at least 2 times the current US inflation rate. For some reason, the eroding power of inflation is making me nervous about the “average market” yield. This way, I have some room for comfort.
July 3rd, 2010 at 10:18 am -
RobberBaron said:
I’m confused. Various articles present the current dividend yield for S&P500 between 2.1% and 2.6%. Why should such a calculation differ so widely?
July 6th, 2010 at 2:04 am
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