The dividends of a company are an important investment component that will heavily determine the investment decision for many investors. The primary way to assess the amount of dividends that you would get from a stock relative to the price is by looking at the company’s dividend yield.
The higher the dividend yield of a stock, the higher the amount of dividends that you would effectively get as a shareholder of the company.
Generally, dividend stocks are often viewed as safe and stable investments that provide a nice additional income stream for investors, but in reality, just like any other stock, there are both good and bad dividend-paying companies. And it is no different from companies that even pay the highest dividend yields.
In the following, we will discuss why a high dividend yield doesn’t necessarily indicate a good investment and thus, why it shouldn’t be enough to only make investment decisions based on the dividend aspect of a stock.
What Makes up the Dividend Yield?
In order to thoroughly understand why a high dividend yield isn’t always good, it’s important to know which components the dividend yield consists of. The dividend yield of a company can be calculated by dividing the annual dividends per share that the company pays by the current market price of the stock.
The two components that can essentially determine the dividend yield are therefore the amount of dividends that the company chooses to pay, and the current price of the stock.
For example, if company X pays an annual dividend $2 per share and is trading at $80, the dividend yield would be calculated by dividing $4 by $80, resulting in a percentage rate of 2,5%.
In order for the dividend yield to increase, either the dividends need to increase, or the stock price has to decrease. If company X’s stock drops from $80 to $50 per share, the resulting dividend yield would suddenly be at 4%.
The other factor that can drive up the dividend yield, is simply the amount of dividend that the company decides to pay. if everything else held equal, a higher annual dividend will result in a higher dividend yield.
Let’s assume that company X decides to increase its dividends, while still trading at the same price of $80. The firm now pays an annual dividend of $4 per share, which would now contribute to a dividend yield of 5%.
The question that should be asked is whether it really was a good decision for the business to raise its dividend. Why should the currently high dividend yield matter to us if it’s not sustainable in the future anyway?
Why A High Yield Isn’t Necessarily a Good Sign
A high dividend yield doesn’t necessarily indicate all the great characteristics that we expect a company with such an attractive dividend to have.
In the example above of company X’s stock price to drop from $80 to $50 per share, clueless investors may now be intrigued by the attractive dividend yield of 4% but the point that they’re missing is the recent price drop that happened to the business. There might be a good reason why investors lost confidence in the stock that resulted in a decreased demand and thus a stock selloff in the first place.
Maybe the business has to face some sort of financial hardship that led its underlying fundamentals to drop to the worse. So despite the great dividend yield of the stock, the company may not be a good investment, essentially being an investment trap for investors that would only look at the dividend yield.
Either way, this is why it’s always important to take a deeper look at the company in the first place.
Another concern is the intention that always lies behind the act of dividends payments that the business chooses to make.
Why does the company pay dividends in the first place? And if a high dividend yield resulted because of an increase in the amount of dividends, why did the company raise its dividends? Was it due to the steady growth of the business, or just to attract investors, despite the bad looking fundamentals? Will the high level of dividends be sustainable in the future? All these uncertainties can’t be clarified just from the dividend yield.
It’s Not Only About the Dividend
There is a good reason why some of the major companies have never chosen to pay any dividends. For some companies, paying dividends is not an optimal way of returning profits back to shareholders since every dollar that is paid to shareholders could have been directly reinvested into the business in the first place.
Growth companies for example, see much better use of all the earned capital invested in further growth, rather than just paying dividends. And investors shouldn’t be worried about not receiving any dividends because their returns will therefore come from immense capital gains instead.
Consistency Is Key
There is no requirement for any business to pay a dividend to its shareholders. Some companies like Microsoft (MSFT), Apple (APPL) or JP Morgan (JPM) may decide to do so, while others such as Facebook (FB), Berkshire Hathaway (BRK-B), or Amazon (AMZN) prefer to not pay any dividends.
Therefore, companies may choose to cut or change the amount of dividends at any given time. Most businesses that pay a dividend will try to keep up a consistent schedule of dividend payments, but the amount of dividends heavily depends on the financial health of the company. So the question is always if the company will be able to consistently pay dividends to shareholders in the future.
One way to assess consistency, is by simply looking at the track record of dividends that the business has already paid:
PepsiCo (PEP) for instance, has a good looking history of growing dividends, along with increasing revenue, stable earnings-per-share, free cash flow, and good margins. You could at least expect PepsiCo to remain the consistency of regular dividend payments with relative confidence based on the financials of the business.
To conclude, the important thing to understand is that even stocks with the highest dividend yields will oftentimes come with some type of caveats that should always be assessed by taking a further look at the company.