“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
– John D. Rockefeller
The moment an investor hears the words “High Dividend Paying Stock”, there is a tendency to entrust this company in order to secure our financial growth. I have mentioned the importance of high dividend stocks in my previous blog post Stock Market Investing – Understanding Indices & Ratios, but I would like to elaborate further on some of the aspects an investor may overlook.
Simply put, a dividend yield is the annual percentage of dividends paid calculated as below:
Div Yield = Annual Dividend per Share ÷ Stock Price
If a stock price is $50 and the company pays $5 as dividends annually, its dividend yield is 10%. While a 10% yield seems like a deal not to be missed, here are some cautionary measures that must be taken first:
1. STOCK SCREENERS
Many investors today wish to take the short-cut route to investing without jumping through the hurdles of fundamental analysis. One of the easiest tools for this purpose is a stock screener, which evaluates certain parameters in order to show the best stocks to invest. For example, click on this link to see the top dividend paying stocks that investors use to make some quick decisions, solely relying on yield numbers.
However, it is imperative to understand the reason behind those high dividends. For example, a recent decline in the stock price could result in high dividend yield. Let’s use the example of the $50 stock with 10% dividend yield. If the stock price declined to $40, the dividend yield will now become:
Div Yield = 5 ÷ 40 = 12.5%
Suddenly the stock appears more appealing only based on this high yield, without considering the decline in the stock price. Investors need to understand factors leading to the rise and decline in stock prices, by clearly estimating the fundamentals of the stock. Thorough research is the foundation for value investing.
2. SUDDEN DIVIDEND PAYOUT
It is a known fact that new and upcoming companies do not generally pay dividends to investors, whereas mature and stable companies often entice investors with high yields. New companies require constant capital in order to grow their operations, thereby avoiding a dividend payout to customers. Does this mean that the moment a company announces a dividend payout, investors should be quick to grab a piece of this company? This is again a misconception that needs to be understood and evaluated. A sudden dividend payout announcement does not necessarily imply maturity and stability, and investors must be patient and evaluate the performance of the stock.
Such announcements usually drive the stock prices upwards, but the company’s future plans and growth forecasts are the real measures of its ability to make investors a good return on investment.
3. HIGH YIELDS NO MORE
During times of uncertainty, companies often reduce dividend payouts to investors, which often results in lower stock prices. Does this mean the stock is no longer worth holding on to? Certainly NOT!
In difficult times, the entire market faces a downtrend, and even a stable company like Apple may announce a reduced or zero dividend payout. However, this is not your time to sell everything in panic, but a time to acquire more stock of great companies when stocks are on sale. Understand that when the economy improves, the stock price will also improve and the company is likely to announce increased dividends as well. You may also want to read 4 ways to harbor your wealth from the next Recession
However, if a new company suddenly reduced its dividend payments, you must carefully evaluate your investment again. Such investments lack any historical evidence of growth when the economy is set to recovery mode, and understanding the business model and leadership of the company are key factors in determining the future for such investments.
Be Frugal, Be Smart, Be Rich!