When Is a Yield Too High?

Reaching for yield is very tempting. The cash flow that I can receive as a result of a good yield is very substantial. However, there are a few things that I try to keep in mind when choosing a high-yielding stock:

1. Has the yield shot up in the past month or so or has it been high for a substantial period of time (1 year+)

If it has shot up, it usually means that the stock price has tanked. It is very important to understand why the stock has tanked. I ask myself questions such as, “Is the drop in price a result of a company controlled issue or a macro-economic (i.e. hurricanes, interest rates, etc) issues?” If the yield has been high for a long time, is it a result of a stagnant stock price or does the company increase the dividend payout as the price rises. The key point here is I try to understand why the yield is high and what is driving it. Best case scenario = company keeps bumping up the dividend on a consistent basis.

2. What is the company’s payout ratio?

According to Investorpedia.com, a company’s payout ratio is, “The percentage of earnings paid out in dividends.” Generally, the lower the payout ratio the better simply because the company is able to support making the high dividend payments in the future. If a stock has a high yield and a high payout ratio this is a warning sign of a pending dividend cut.

3. Of course, all other fundamental data needs to look good

I never buy based on yield only. All other data must look good as well – increasing earnings, increasing revenue, a p/e ratio less than the market and less than the industry, positive cash flow etc. I like to check out the Snapshot Page at Morningstar.com to get a good picture of what some of the ratios are saying.

If all signs look good, then I would feel comfortable making a purchase.

In summary, a high dividend yield is a very cool thing to have. However, making sure the rest of the picture for the company looks good is, in my opinion, even more important. Let me know what you think.