The dividend yield is found by dividing the dividend per share by the stock price. This ratio measures the annual percentage cash return to the investor on the stock. In addition to the dividend from the stock the investor would also be looking for a return from an increase in the stock price, so stocks with a lower dividend yield may be expected by an investor to deliver higher future growth in the value of the stock.
Some of the advantages of high dividend yield stocks are obvious. An investor may want a reasonable income from investments and will therefore benefit from regular dividend payments. Another possible advantage is that an investor who receives regular high dividends on the investment is getting something back from that investment, whereas an investor in a growth stock that does not pay dividends may risk losing a great deal of the investment without gaining anything in return in the case of a reversal of fortunes in the enterprise.
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The management of a company paying high dividends could be misjudging the enterprise’s financial position and it is therefore important for the investor to look at the fundamentals and to form an opinion of the competence of management. This management may be pursuing an unrealistically ambitious dividend policy and not putting enough funds back into the business. They may be trying to keep the share price higher at the expense of the needs of the ongoing business operations. Investors must be sure that they will not lose out in the long term because of high dividends in the short term.
Some dividend investors are interested in dividend yield but also in dividend growth. To analyze stocks simply in terms of the dividend policy without examining other metrics and the performance of management is incomplete. The high dividend yield stock could be enjoying a short term boost that will not last. This can only be revealed to the potential investor if other factors are analyzed. The business may be cyclical and enjoying one of its upturns at the present time. The investor should therefore look at the development of the dividend yield over a number of years. The policy of high dividends may not be sustainable.
Looking at high dividend yield stocks as a part of an investment strategy can work if the stocks are also analyzed using other principles of value investing. An analysis of profit or liquidity ratios may indicate the sustainability of the dividend policy. An assessment of the quality of the management can allow a more realistic assessment of the future of a high dividend yield stock.
The investor can run an eye down the financial pages looking for the high dividend yield stocks and identify some opportunities that look attractive. The first step is to ensure that the high dividend yield is not just a temporary phenomenon and is sustainable. This gives the investor a first indication that the stock may be worth looking at more carefully. The value investor must approach high dividend yield stocks in the same way as other investments and apply the customary tests before making the final investment decision.
Reasons to be Cautious
The dividend paid out on a stock ultimately depends on the dividend policy of the management and does not tell the investor everything about the stock. There are a number of reasons why focusing on dividend yield does not convey sufficient information to form a rational investment decision. As already mentioned, many corporations may prefer to use profits generated to grow the business and keep dividends low or not pay out dividends at all. Even where they are not using the cash for new projects or purchasing new assets, the management may prefer to keep large cash balances, reducing the dividends payable. The highest dividend yield stocks may not therefore represent the best value stocks.
The value investor must look at other ratios such as free cash flow to equity. Cash flow or profit ratios are an indicator of the health of the enterprise whereas dividend yield is affected by the dividend policy of management. The free cash flow measures the amount of cash that would be available to pay out as dividend, independently of the amount of dividend the directors decide to actually pay out. This is a better measure of the health of the company.
The value investor should also remember the lessons learnt by other investors over the years. It is unwise to move outside the circle of competence and invest in a company in an unknown and poorly understood industry. For example, an investor who is not familiar with the trends in information technology should hesitate before forming an opinion of the prospects of an enterprise in that industry. The investor should be in a position to form a view of the intrinsic value of the enterprise and compare this to the current valuation. As always the investment should be made if the price is below the intrinsic value and there is a good margin of safety.