Beware the High Dividend Yield Trap

Companies that pay dividends can be wise investments, especially if you hold their stocks 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.

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 its 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.

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.

Dividends are paid out of cash, which comes from earnings. You should determine whether 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, whether 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 among the many different essential ratios to consider while evaluating a company.