Dividend investing is a tried and true strategy, providing investors with both income and the possibility of a rising share price. Not only have many models shown investing in dividend stocks to be a more successful long term strategy than investing in growth stocks, but some qualifying dividends are taxed at a lower rate than capital gains. That said, most shrewd investors know that a dividend yield that is too high usually signals trouble. There are a number of reasons why this might be, including:
The dividend is being paid by accumulating debt. When a company pays a dividend out of the sale of assets, the jig is nearly up, but only slightly better off is the company that pays a dividend by going (deeper) into debt. Holding a certain amount of debt can be quite sensible, so the trick here is knowing whether a company is taking on so much debt that it is damaging its future prospects. You’ll hear a lot of theories about the best way to determine this, but the simplest method —and frequently the most telling—is to check the company’s debt ratio, which is its liabilities divided by its assets. If the debt ratio is steadily rising, and particularly if the rate of its rise is increasing, the company is probably in trouble of one kind or another. At the very least, it will probably not be able to sustain its dividend much longer.
The dividend is about to be cut. You can’t see the future, but you can watch for patterns, and if you don’t, you could be setting yourself up for a disappointment. Let’s say company XYZ has been paying $0.25 per share as a dividend for the last three quarters, and its earnings per share have been above $1 per share in each of those quarters. Then suppose it earns less than $1 per share in a particular quarter. It would be very wise to look at XYZ’s historical dividends and earnings per share. Suppose that in every previous quarter when XYZ has made less than $1 per share, it has paid a dividend of only $0.10. Those who have spotted the pattern will likely sell XYZ stock, pushing its price lower and its apparent dividend yield higher, making the stock more attractive and less rewarding to investors who haven’t done their homework. Don’t be one of those.
The dividend is being paid by the sale of assets. There are a number reasons this might happen. Managed Payout Funds, for example, always pay out 100% of their value by a set date, and therefore sell assets to pay dividends by design. Looking beyond this rather special case, however, there are also cases where companies feel that they are better off losing certain assets than they would be missing a dividend payment, but this tends to bode poorly for the company’s ability to continue to pay dividends in the future. In a worst case scenario, a company may attempt to hide the sale of assets and give the appearance that it is paying a legitimate dividend out of its earnings. Benjamin Graham once famously said, “You can’t fake a dividend.” That’s true, but you canfake sustainability. While there is no way to be certain of a company’s honesty, you can at least steer clear of any company where the management has any history of questionable accounting practices.
The dividend has already been cut. You might not think this would be such a problem in the age of instant information, but it is. If you require confirmation, type the ticker of a dividend paying stock into ten different websites. You will likely see more than one dividend yield listed. This is because when it comes to going forward value, the dividend yield is only an estimate, and it is estimated differently by different analysts. Some compute the dividend yield by considering the dividend in the last four quarters, while some use only the most recent quarter and multiply by 4. To see how large an impact this can have on the numbers, consider again the example of XYZ above.
Suppose a few weeks have passed, and XYZ has declared its lower quarterly dividend of $0.10 per share, causing its price to fall from $12 per share to $9 per share. Website A computes the dividend yield by examining the past four quarters, which is $0.85 divided by $9, or 9.4%, up from 8.3% in the previous quarter. Website B computes the dividend yield by multiplying the most recent dividend by 4, which is a dividend of $.40 divided by $9, or 4.4%, down from 8.3% in the previous quarter. A you can see, Website A’s method not only shows a dividend yield more than twice as high as Website B’s, but Website A shows a rising dividend yield, while Website B shows it to be falling. In this case, Website A’s method looks inaccurate, even deceptive, but that is almost certainly not the intent. In cases where a dividend rises and falls unpredictably, Website A’s method may be more reasonable and accurate than Website B’s.
The only solution for a serious investor is to examine a company’s dividend, make your own assumptions about what that dividend will be during the period of time you intend to hold the stock, and make your own calculation of the dividend yield. If you aren’t sure what the dividend will be, you should use what you feel to be a reasonable range for the dividend to determine the range of the likely dividend yield. This method requires a bit more work, and the result is a bit vague, but it is better to be vaguely right than precisely wrong.