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Beware the Dividend Yield Trap

High Yield May Signal Problems

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Companies that pay dividends can be wise investments, especially if you hold the stock over a long period.

When you add the dividend into any price appreciation, you can enjoy not only current income, but growth too. Of course, you can reinvest dividends if you don’t need the current income.

One way investors look for high dividend paying stocks is by using dividend yield as a guide. Dividend yield tells you what percentage the stock returns relative to its price.

Calculating Dividend Yield

You calculate dividend yield by:
Dividend Yield = annual dividend per share / stock's price per share

For more detail of the calculation, see Understanding Dividend Yield.

You can search for companies with high dividend yields using any one of several stock screens. One I often use is MorningStar.com.

While you can get a list of companies with high dividend yields this way, you must not make investment decisions using just this one metric. Things are never that simple in investing.

Dividend Yield Trap

Dividend yield can lead you into a trap if you’re not careful. If you’re good at math, you noticed that the divisor of the formula for dividend yield is the stock’s price per share. If the price drops and the dividend remains the same, the dividend yield will rise.

You may buy a company with a high dividend yield, but one that is also on its way to the poor house and may not be able to afford to pay any dividend in the near future.

What do the other fundamentals look like? Dividends are paid out of cash and cash comes from earnings. Does the company have a healthy supply of cash and a consistent history of earnings and earnings growth?

If a company has just taken on a huge debt through an acquisition, for example, how is that going to be paid? Will it suck all the free cash out of the company?

If you look at the MorningStar stock screen, you’ll notice that the dividend yield was only one of many parameters you could pick.

Set the screen to pick companies with a history of strong growth and earnings and a forecast of continue revenue growth along with a high dividend yield and you may have an investment candidate.

Conclusion

Companies with a high dividend yield may be great investments if the rest of their fundamentals fall into line also. Just be careful when one metric looks good and the rest are questionable. That’s a sure sign that not all is right with this company.

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