Dividend-paying stocks are attractive investments. Who doesn’t like getting paid to own a stock? But is a higher yield always better? To answer perhaps let’s start with a refresher on the mechanics at play.
The dividend yield is a simple equation: the quotient of a company’s dividend-per-share divided by its price-per-share. Imagine fictional company Best Coffee. If its stock price is currently $20.00 and it pays an annual dividend of $1.00, the dividend yield is a healthy 5%. Then Best Coffee’s dividend yield suddenly jumps to 10%. You may hope boosted earnings from its newly introduced dark roast coffee are the driver of dividend growth, but that sort of lift takes time.
The quickest way for the yield to go up is for the stock price to go down. If the stock price gets cut in half—say $10.00—with the same $1.00 dividend, you instantly have a 10% yield.
We invest in an ultralow-rate environment. GIC interest rates, bond yields, and other conservative income-producing investments pay paltry sums. Yet today’s retirees are hungry for income to live off. This compressed interest rate state tempts investors to chase yield; wrongly judging the attractiveness of a security primarily by the size of its yield. This can be dangerous to your capital.
So Best Coffee now has a 10% dividend yield. Before getting too excited, recall that this higher yield came not from a robust increasing, top-line dividend but instead from the halving of its stock price. This may be a case where that ‘attractive’ high dividend yield is whispering a warning to you.
If the yield is high relative to its peers due to price weakness, it signals the market is pricing in added business risk. Maybe Best Coffee spent millions advertising its new dark roast blend only to see same store sales flat line. Perhaps the increased expenses and the failed attempt at growth have tightened operating cash flow and the dividend is in jeopardy of getting cut.
Here dividend yield may be high but only as a function of the pressure on the price. The pressure on the price reflects Best Coffee’s changing fundamental profitability picture. And that changing profitability picture is causing fear that the dividend is not stable. It’s a potential downward spiral.
Our point is simple: if it is too good to be true then maybe it is. Do not swallow the bait.