For the dividend investor, nothing is more alluring than a high yield. However, yields approaching 12-15% could be a sign that a stock is headed for trouble that could leave you with no income and a dud share price.
To refresh your memory, a dividend is a regular payment of income made by a company to its shareholders, and the size of the payment is usually announced in the company’s annual report. Stocks with a relatively high dividend are attractive for several reasons.
For one thing, most companies listed on the Australian Stock Exchange (ASX) have fully-franked dividends, meaning the company – not the shareholder - pays tax on the dividend payments.
Many companies also enable you to re-invest your dividends to buy more shares in the company, which can produce exponential returns for you over time.
So why would you need to be concerned about high dividend yields?
The ‘dividend yield trap’
Just to recap:
Dividend yield = dividend payment / share price
A stock with a high dividend yield may be producing unsustainable returns. For instance, a high yield may actually be an indicator that the stock’s share price has fallen. A falling share price could signal serious issues in the company, such as management problems, cash flow problems or consistently negative profit outcomes.
If management continues to have trouble addressing such problems, it could cut dividend payments as a last resort. If you’ve purchased a stock purely for its high dividend yield and you’re an investor that relies on regular income, you may find yourself in what is known as the ‘dividend yield trap’.
The company stops paying you dividends and its share price has declined so if you sell you could actually lose money. Suddenly you’re stuck and what looked like an attractive yield turns sour.
It’s best to do some company research and find out if the company’s management has ever reduced its dividend payments in the past. If they have done so – even once – it is not a good sign.
Sometimes a company may issue debt, which can increase its risk profile. If things worsen considerably for the company, then debt-holders will recoup funds before ordinary shareholders.
Another issue to be aware of is that your returns would be diluted if you do not take up a rights issue – that is, if they do not maintain the same proportion of shares in a company, when new shares are issued.
High dividends now, less growth in the future?
The other important indicator is the payout ratio, which identifies how much of a company’s earnings are used to provide dividends.
Payout ratio = dividend payment / earnings per share
Benny Sada from Australian Stock Report and Bruce Jackson from Motley Fool suggest a company’s payout ratio should be a maximum of 70%.
Although a larger payout ratio implies shareholders receive higher dividends, it also means the company is investing less of its earnings into new opportunities to increase profit, such as establishing a new factory or purchasing improved technology. Keep mind that dividends can only increase over time if profit is rising.
British writer Matthew Lynn says: “In many cases, rising dividends are a sign that CEOs have become too nervous about taking risks – and that is hardly good news.”
Some of the world’s most successful, valuable companies barely have a dividend payment history. The last time Apple paid dividends to shareholders was in 1995; Google has never paid dividends at all. The earnings from these giants were re-invested back into the company, and clearly produced successful outcomes.
-- By Stephanie Hanna