Beware the High Dividend Yield Trap

High Yield May Signal Problems

Dividend Yield
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Companies that pay dividends can be wise investments, especially if you hold the stock over a long period. Dividend yield tells you what percentage the stock returns relative to its price.

When you add the dividend into any price appreciation, you can enjoy both current income and future growth. Of course, you can reinvest dividends if you don't need the income.

One way investors look for high dividend-paying stocks is by using dividend yield as a guide. However, investors sometimes run into problems when relying on dividend yield as a measurement. It helps to understand what dividend yield tells you and what it doesn't.

Calculating Dividend Yield

Examining a stock's dividend yield reveals how much of a return you're getting from a particular investment. For example, if a stock trades at $25 and the company's annual dividend is $1.50, the dividend yield is 6% or $1.50 divided by $25.

Dividend Yield

You can search for companies with high dividend yields by using a stock screening service or doing the math yourself. One service you can use is Finviz. Their stock screener lists companies, and you can choose to filter them by their dividend yields.

When you choose one, you're taken to the stock's page, where you can view their candlestick chart, earnings and other fundamental information.

Finviz lists a stock's annual dividend yield on the stock summary page to make it easy for investors and traders. You might see a company's annual dividend listed at $.96 and the annual dividend yield of 3.02%. The stock's latest closing price can be used to calculate the current dividend yield.

While you can get a list of companies with high dividend yields using this method, it's essential to remember that investment decisions shouldn't be made using one metric.

The Dividend Yield Trap

Dividend yield can lead you into a trap if you're not careful. The divisor of the formula for dividend yield is the stock's price per share. If the price drops and dividends remain the same, the dividend yield rises.

If PFC's stock price dropped to $25.03 per share, its dividend yield would be 3.84%. While this might appear to be an exciting development for a stockholder, it could also show that the company is worried more about shareholders than funding operations and growth.

Keep in mind that if you're using a stock's current or last few months' closing prices to evaluate dividend yields, it might not be an indicator of a problem because stock prices constantly change for many reasons.

You can compare daily prices and monthly average prices to identify any trends and use that information along with fundamental analysis to figure out what the stock might be doing.

How to Avoid the Trap

Analyzing a stock using information from a fundamental analysis helps investors develop a holistic view of a company's financial performance, liquidity and solvency.

Liquidity is a measure of how quickly a business can turn assets into cash, and solvency measures if a company can pay its obligations.

Dividends are paid out of cash, and cash comes from earnings. You should determine if the company has a healthy supply and a consistent history of earnings and earnings growth.

If a company has just taken on a considerable debt through an acquisition, you need to know before you invest if it has enough cash and assets to pay its obligations. It also needs enough to pay dividends, fund its operations and reinvest in itself.

This is where other fundamental ratios come in. Working capital, the quick ratio and the debt-to-equity ratio are some (among many) of the different essential ratios to consider while evaluating a company.

The Bottom Line

The dividend yield is just one of many parameters you can examine through a free stock screener like Finviz or StockRover. Morningstar is a favorite for investors and traders but requires a subscription.

Companies with a high dividend yield may be excellent investments if the rest of their fundamentals also fall into line. Take care not to focus on one metric when it looks good, but the rest are questionable. That's a sure sign not all is right with the company.

It's essential to look at total annualized return over periods of months or years because a high dividend won't compensate if the stock price is continuously declining. A quick look at the company's investor news, press releases or industry reports can also help determine a company's standing.