When I first started out investing in dividend paying stocks, I really had no clue what I was doing. I had been buying and selling investments for several years but had no experience selecting blue chip stocks that paid a dividend. My screening criterion (at the time) was flawed and it cost me a couple thousand dollars.
What was my major flaw in selecting these investments for my portfolio? I focused only on the dividend yield of a stock instead of looking deeper into a company’s financial numbers and history. I only considered the highest yielding stocks for my portfolio and didn’t even look at blue chip companies like Procter & Gamble (PG) and Johnson & Johnson (JNJ). The dividend yield on those companies was just too small compared to other investments.
If you are planning to build a portfolio of dividend paying stocks, take my advice and don’t chase the highest yielding companies. Keep reading and I will tell you why.
Highest Yielding Dividend Stocks = Risky Investments
Who wouldn’t love a 10% return on their investment in the form of a cash payment every year? Many of the highest yielding stocks actually have current yields well above 10%. Picking a stock that offers a double digit payout every year may seem like the best financial decision you ever make. I am here to tell you that it is also probably one of the riskiest investments you could ever make.
The first dividend stock that I ever bought paid a monthly dividend with a yield of 15%. During the first year of owning the stock, I received a $25 monthly dividend payment for my $2,000 investment. Just in the first year, I made $300 in dividends from owning the stock.
Soon after the first year of holding the stock, the bottom fell out and the yield came back down to reality. What once was a hefty 15% yield became a 7% yield in less than a week. My steady $25 per month income stream had been cut by more than half before I knew what had happened. What I learned in the few weeks after the stock price took a tumble was that the company had a payout ratio above 100% and could no longer maintain its dividend at current levels.
Up until that point, I had no clue what a payout ratio even was. The payout ratio is the amount of earnings used to pay dividends to common shareholders. Common sense would have told me that any company that pays more in dividends than they earn is not a good investment.
Types of High Yielding Stocks
Not every high yielding stock is created equal. Many of the highest dividend stocks come from corporations that are setup as trusts. For example, many real estate investment trusts (REITs) have very large dividend payouts. Some of these companies can make for decent investments, but you better do your homework.
Another group of high yielding stocks are from companies that are ready to make a dividend cut very soon. Since the current yield of a stock is calculated using past dividend performance with the current share price, there can be a delayed change in the results. The market saw this kind of behavior after the sub-prime crisis with companies like Bank of America (BAC) and Wells Fargo (WFC).
Here is an example of what could happen when a company is getting ready to cut their dividend. Let’s assume company ABC pays $1.00 annually in dividends and trades at $25 per share. The dividend yield for this stock would be 4.0%. Let’s also assume that the company has warned they will not meet their earnings numbers for the next quarter and the share price plummets to $15. Since there is no immediate change in the dividend paid, the current yield would jump to 6.7%. In a situation like this, there is a very good chance a dividend cut is looming by the company because of their earnings problems.
In the scenario above, if you didn’t do your homework and invested in ABC with a 6.7% yield, you would be at a disadvantage when the company makes a cut. While this scenario does not cover every situation, it is common to see this happen when a company has cash flow problems.
Picking Top Dividend Stocks
With savings accounts and certificates of deposits currently returning 1% – 2%, it may be tempting to chase the highest yielding stocks. Even if a CD was paying 5%, it can still be difficult not to consider investing your money into a stock that is yielding 10% or 15%. However, I caution anyone considering this type of investment to do their homework on the company before they chase the high yield.
It may sound simple, but the key to picking the top dividend stocks comes down to common sense. If a 10% yield on a stock seems too good to be true – it is. If that double digit return was a great investment, then everyone else would be climbing on board which would increase demand to own the stock and thus decrease its yield. The main point to remember here is that there is a very good reason why the stock has that high of a yield.
While the current yield of a company is an important way to screen dividend stocks, there are several other ratios and criteria that should be considered as well. Here is a list of a few useful indicators you can use when selecting the top dividend paying stocks.
- Current Yield – Any stock that has a current yield greater than 6% should be studied very carefully. It is almost impossible for a company to maintain a yield higher than that.
- Payout Ratio – How much of a company’s earnings is being used to pay the dividend? The best blue chip companies are able to sustain a payout ratio of 50% or less. While maintaining and growing a dividend is important, it should not come at the expense of growing the company. A company that is allocating too much of their earnings to pay shareholder dividends is not allowing themselves to grow.
- P/E Ratio – The price-to-earnings ratio is another critical indicator that investors should consider to find the best dividend paying stocks. You never want to overpay for a blue chip stock. Look for companies with a trailing P/E under 20 to find the best value in the market.
- Dividend Growth – Does the stock have a history of raising dividends every year? While it is critical that a company not sacrifice additional earnings every year to raise the dividend, it is important to see growth. Look for companies that have a strong history (at least 10 years) of providing raises to their shareholders annually. Look at the dividend aristocrats index or the dividend achievers as a place to start.
The criteria listed above are just a few of the additional indicators that investors can use to weed out the risky high dividend stocks.
If you want to build a solid portfolio of stocks that can provide a source of income in the future, take my advice – don’t chase the highest yielding stocks. Instead, put together a portfolio of stocks that have historically increased their distributions annually. Look for companies that are well managed and can withstand any type of economic environment. Most of the time, chasing high dividend stocks will cost you money instead of earn you more.
Do you invest in the highest dividend paying stocks?