When Is A High Dividend Yield Just Too High?

By Miranda Marquit
May 13, 2013

When I started playing around with the idea of dividend investing, I was all about the yield. Many dividend investors are.

Chasing the highest dividend yield seems like a fool-proof strategy. After all, it means higher earnings each payout. And we all want higher payouts.

I learned quickly, though, that a high dividend yield doesn’t always mean that a stock is a good choice. In fact, there are times when a high dividend yield means trouble.

Dividend yields are calculated by dividing the annual dividend amount paid per share by the price per share. So, if a stock’s price tanks, the dividend yield shoots higher.

Let’s say you invest in a company that pays 15 cents per share each quarter. That means an annual dividend of 60 cents per share. The stock price is $20 per share. At that level, the dividend yield is 3%. That’s not too bad. But if the stock price plummets to $12 per share, the dividend yield jumps to 5%. Now we’re talking...except that if you’re chasing yield, you might actually be investing in something that isn’t fundamentally sound.

But before you invest in a stock with a high dividend yield, look at recent history. Unless you think that the new, lower stock price means that a company is undervalued, you might want to stay away.

Another consideration is that some companies boost the dividend yield in an effort to attract investors -- even though the company is in trouble. An attempt to lure investors with a high yield can be a sign that financial trouble is on the way. A high yield might mask fundamental problems with a stock.

Is that yield even sustainable? While it’s possible to create a dividend investment strategy around frequent trades to ensure that you always have the highest yield possible, the fees incurred can offset your earnings.

Much of the time, a truly high yield is unsustainable over any length of time. If you are trying to build a long-term income portfolio with dividend stocks, you want yields that are sustainable. The highest yields are those most likely to be cut, since companies that offer such high yields can rarely keep doing so.

Startup companies, for example, sometimes offer high dividends to attract new investors. While there is the chance for earnings growth as well as great dividend opportunities with a startup, you also face greater risks.

Indeed, there are times when a high dividend yield -- especially if the dividend yield has moved significantly higher in a short period of time -- is an indication of volatility. If you are looking for a solid, fundamentally sound investment, the last thing you want is a great deal of volatility and capital risk.

Rather than looking only at whether a dividend yield is among the highest, consider companies that have a track record of sustainable dividends. A company that pays a consistent dividend, especially if the company raises its dividend regularly over time, has potential for reasonable capital gains as well as dividend earnings.

A company that can sustain dividend increases over time (even if they’re small) is generally a company that is fundamentally sound. Consider the so-called dividend aristocrats. Their yields aren’t always the sexiest, but they are usually solid. And dividend aristocrats are companies that have increased their yields at least once a year for the past 25 years. Some of the companies on the dividend aristocrats list have increased dividends yearly for more than 40 years -- including during the Great Recession.

That’s income you can count on.

The Investing Answer: Don’t get so caught up in yield that you forget to consider other factors when choosing a dividend stock. If you want long-term income from sustainable dividend payouts, the highest dividend yield is rarely your best option. Instead, look for companies with strong fundamentals and historically reliable dividends.

P.S.: And if you're looking for a smarter, safer and more profitable approach to income investing, my colleague Carla Pasternak has discovered some little-known companies with incredibly strong business models, impeccably clean financial statements, and long histories of increasing dividend payments and delivering outstanding total returns. What does this mean for you? Quite simply, an outsized second-income stream. Called the Retirement Savings Stocks, this presentation explains it all here.