Dividend Yield: Higher Is Not Always Better

There are two main types of stocks: growth and income.

Growth stocks are the shares of companies that are expected to experience faster revenue growth than average. Ideally, earnings are growing at a fast pace, too. However, if a company is young, investors will overlook losses now if they expect it to become profitable not long down the road.

These companies typically are reinvesting a large portion of cash they generate back into the business for growth. Thus, they generally either don’t pay a dividend at all, or pay a low dividend.

By contrast, income stocks pay a higher dividend to shareholders. These are usually mature companies or they are companies whose business model or organizational structure make them fit for generous dividend payers.

Read This Story: Dividend Stocks: “Boring” But Bountiful

When a company doesn’t have a great number of growth opportunities, one option it has with the cash on hand is to return some cash to shareholders.

For example, utilities are regulated businesses so their growth is limited but they also have very little competition in their geographical markets and generate steady cash flow.

The Dividend Yield

You will want to know the dividend yield, which measures how much dividend you are receiving compared to the price you pay for the stock. The dividend yield is calculated by the annual dividend divided by the stock price. Higher is not always better.

If you see a dividend yield that seems unusually high, it’s prudent to look deeper at the company. There could be something seriously wrong with the company or the perceived risk is so high that investors demand a higher yield by pushing the stock price lower.

After all, consider a stock that pays $1 per year in dividend. At $25 a share, the dividend yield is 4%. But if the stock falls to $10, the yield has jumped to 10% without any increase in dividend. In this case the 10% yield is not a good thing. The investor needs to find out the reason(s) for the price drop before buying shares.

If the company is experiencing financial distress, there’s a good chance the dividend will be cut. Continuing our example above, if investors anticipate a dividend cut, they will proactively reset the stock price downward. Let’s say the company indeed cuts the $1 dividend in half to $0.50, then the new yield will be a more normal looking 5%.

In other words, a super high yield may be a mirage because the dividend could fall.

On the other hand, a company that generates consistent and growing earnings and cash flow will likely be the better bet over the long run even if the yield is, say, only around 2.5% or 3%. The key is that the company can easily cover its dividend obligation, and there’s an excellent chance of continued dividend increase over time.

Growing Dividend Helps to Offset Inflation

Remember, inflation rises over time. The same $100 will buy less and less. For this reason, you would actually be losing spending power with money locked into fixed income instruments.

Dividends, however, are not fixed. Growing dividend will at least partially offset inflation. And if the dividend increases at a higher rate than the inflation rate, even better! In this case, you would be earning a positive real return (i.e., adjusted for inflation). Your buying power goes up.

Thus, investing in a quality company that has the ability to pay a sustainable and growing dividend is more important than yield alone. A quality company’s stock is also likely to appreciate in value over time.

Investors who fall for the high-yield trap and invest in a weak company often find themselves suffering a loss even with a 15% dividend yield. This doesn’t mean that all high-yielding stocks are automatically bad, but an investor must do his/her homework before risking hard-earned cash on the stock.

Not So Boring Anymore

Going back to the aforementioned utilities, nowadays many utility companies have added regulated businesses to their traditional regulated business, so they are not the boring low-growth or even no-growth companies they used to be.

The unregulated businesses are often in renewables or ancillary services such as water treatment. The regulated businesses offer higher potential growth and thus offer a balance of growth and stability to the overall company.

The right utility stocks can provide both dependable dividend streams and potential for capital appreciation. For our “dividend map” of the best utilities stocks to buy, click here now.