Beware the siren call of high yield stocks. Fat dividend yields can seem very alluring, particularly in this low interest rate environment. But investors are usually better off sailing right past them.
Many high yield stocks have very little room to raise their dividends over time or invest for future growth. And even a small drop in income can lead to a dividend cut. While dividend cuts are most common during recessions, they can occur at any time, as you can see here.
When it comes to dividend investing, the tortoise often beats the hare. That’s why investors should focus on dividend growth potential more than the current yield.
What to Look for Instead
Income-hungry investors need to keep a long term perspective and consider where a company’s dividend might be in the future. There are several factors to consider when determining a company’s dividend growth potential.
One important metric to consider when analyzing the sustainability and growth potential of a company’s dividend is its payout ratio. The payout ratio is simply the percentage of net income a company pays out to shareholders in dividends. Or better yet, calculate the percentage of free cash flow that it pays out in dividends. All of this can be found on a company’s cash flow statement. Free cash flow is just cash flow from operations less capital expenditures. And dividends paid will be found in the cash flows from financing section.
With market volatility building, it’s time to find a smoother path to outperforming the S&P 500. You may be tempted to snap up stocks that are paying high dividends, but beware.
Big payoffs don’t always lead to profitable investments. Sometimes companies pay too much and don’t keep enough cash to grow their businesses. High dividends can be great but only when they come from healthy, growing companies that will also see soaring (not falling) share prices.
That’s why Zacks has infused an income strategy with dynamic potential growth.
A company with a relatively low ratio of dividends to free cash flow has a much greater ability to raise its dividend than a company with a high payout ratio, all other things being equal. And if a company is consistently paying out more in dividends than it generates in cash, that should be a red flag to investors that the dividend may get cut. This is especially true if the company has levels of debt.
That’s why dividend investors need to look for strong balance sheets too. Companies are not required to make dividend payments like they are debt payments. So if times get tough and money gets tight, checks to the bank and to bondholders will get sent out before your dividend check.
Moreover, if a company is paying out all of its earnings in dividends, it won’t have anything left over to grow the business.