When investing in dividend paying stocks, the dividend yield is obviously a factor that is part of most initial dividend stock screens. High dividend stocks, meaning those stocks that offer a very high dividend yield, seem attractive when yield is viewed in isolation.
As we know, investing in dividend paying stocks is more complex than just searching for the highest yield. In fact, we know that high dividend stocks are often priced as such because there is a fundamental problem with the company and the extremely high yield is a signal of significant risk.
In the past we have learned to further investigate dividend yield with a number of factors.
Average Dividend Yield
First off, we like to compare a company’s current dividend yield to the average dividend yield offered by that company over time – 5-10 years is sufficient. The methodology here is to determine where the company is priced in terms of dividend yield based on where the market typically prices the company.
If the current yield is significantly higher than the average yield for that company over time, then it may be a buying opportunity. However, if the yield is extremely higher than the average, it may also be a signal of additional risk – something significant has changed and needs to be investigated.
Dividend Payout Ratio
Secondly, we must determine if the dividend payout ratio is within the normal range for the company. For example, if a company has an average dividend payout ratio of 40% and the current payout ratio is 80% then we must investigate the reasons for the change.
Most dividend paying companies companies have a policy that attempts to maintain a certain percentage of profits that will be paid out as dividends. If the dividend payout ratio moves significantly higher than the stated range, investors may be looking for a dividend cut!
With high dividend stocks, it isn’t uncommon to see dividend payout ratios greater than 100%. Obviously, it doesn’t take a genius to determine that paying out more in dividends than is earned in profits is unsustainable. This is why the examination of the current dividend payout ratio in relationship to the average for the company is a useful exercise.
To further illustrate the previous points about high dividend stocks and looking beyond the yield, let’s view a couple of examples.
As we can see, both Yellow Media and Proctor & Gamble offer dividend yields greater than their own 5-year average yields. Both give higher yields than the industry average, and both offer a better 5-year average yield than the S&P 500.
However, on one hand, we have Proctor and Gamble that is currently paying out 48% of profits in dividends, while Yellow Media is paying out, an unsustainable, 1o1.84%.
Perhaps even more importantly is how the payout ratio relates to the dividend growth rate. If the payout ratio is high, that leaves little (or no) room for reinvestment in the business. If there is no reinvestment into the business, the potential for growth is limited.
As the data indicates, the dividend growth rate over the past five years for PG has averaged 11.81% , while Yellow Media’s dividend has remained essentially flat. If an investor has a long time horizon, the growth of the dividend may be more important than the initial yield.
Of course, there is more to evaluate than average yield and payout ratio when screening for dividend stocks, but these are two excellent metrics to evaluate when screening for high dividend yields that are sustainable.