How to Look Beyond the Dividend Yield
Not long ago, the market expected interest rates to climb rapidly. This hurt income stocks because their dividend yields don’t look as appealing. People think they can get comparable interest elsewhere without the perceived risk of stocks.
But due to trade tensions and concerns about the global economy slowing, fast-rising rates haven’t materialized. In fact, the flat or inverted Treasury yield curve has been a point of concern for investors lately.
With interest rate expectations now subdued, investor interest in income stocks have rebounded. Compared to low bond yields, stock dividend yields are attractive. Plus, when you invest in a stock, the dividend can rise over time, giving you income growth. For bonds, unless you invest in bonds with variable interest rates, their bond coupon payments are fixed — bonds are commonly referred to as “fixed income” for a reason.
The Yield Isn’t Everything
However, when you are shopping for generous dividend-paying stocks, don’t make the mistake of looking only at a stock’s dividend yield.
However, the yield is a surface number that doesn’t tell you the whole story.
When analyzing a stock, there is a long list of factors you could look out for. To keep things simple, I will highlight a few that I think are most important.
Dividend History and Growth
You should find out how the company managed its dividend policy over time. Some examples of questions you should ask are has the company ever suspended or reduced dividend? Does the company consistently increase the dividend? How fast has the dividend been growing in recent years?
Most dividend-paying U.S. companies pay a dividend every quarter, and they are usually transparent as far as how much they plan to pay in the near future and whether they plan to increase it.
The payment schedule is regular so you can predict with good accuracy when the next payment will be. When a company suddenly changes its dividend policy in a negative way (e.g., suspension, reduction, etc.), that’s usually a bad sign for the company’s financial health.
Beware that foreign companies stick to a much more variable schedule. Their dividend payments can fluctuate wildly year to year and they usually pay either once or twice per year. So in this case irregular dividend payments aren’t necessarily a warning sign. You would have to consider other factors about the company.
Dividend Growing Faster or Slower?
You should also find out how fast the company’s dividend growth is and whether the growth is accelerating or decelerating. Usually, a company that has only recently begun to pay a dividend will show a few years of accelerating dividend growth until it reaches a normal pace.
However, if a company with a long history of dividend payment accelerates dividend growth, it’s usually a very good sign that the company is enjoying new tailwinds.
On the other hand, a company with decelerating dividend growth has probably reached a mature phase. Another possibility is that the company is running into financial trouble, but usually in this case the company would more likely cut its dividend than gradually reduce dividend growth.
The Payout Ratio
Another metric to watch is the payout ratio, the percentage of a company’s earnings that is paid out as a dividend.
A low payout ratio typically means that the dividend is safe and the company has room to increase its dividend. It also suggests that the company is reinvesting profits for growth. A high payout ratio typically means the opposite.
A payout ratio over 100% means that a company is paying out more in dividend than it’s earning in profits, so you should dig deeper to see how the company is funding the dividend.
However, earnings can be misleading because it includes non-cash accounting adjustments, such as depreciation or write-offs. Cash flow provides a clearer picture. After all, the dividend comes out of a company’s cash coffer. For that reason, I prefer to look at the cash dividend payout ratio — the percent of cash flow that the company is paying out. Here, too, a lower ratio is generally better.
Special types of income-oriented investments such as real estate investment trusts (REITs) and master limited partnerships (MLPs) will report special metrics. For REITs, they report funds from operations, and for MLPs, they report distributable cash flow. Both provide insight into how much cash flow they are generating. The idea is still the same, a lower payout ratio is usually better.
To sum up, a company with a lower yield but a faster dividend growth rate in recent years and a lower payout ratio than another company is likely the better long-term investment.
Yield and Risk
Another way to think about the yield is the return an investor requires for investing in the stock. In other words, investors think the stock is risky, therefore they sell the stock until the yield is high enough to justify the perceived risk. Remember, the formula to calculate a stock’s current yield is annual dividend divided by share price. So a yield can rise either when the dividend increases or if the stock price falls.
Therefore, a company paying an abnormally high yield is not necessarily a good investment, especially if the yield significantly rose without an actual increase in the dividend because this means the stock price fell a lot. A rising yield without growth in cash flow is a bad sign. A dividend cut is probably around the corner.