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.
Growth vs. Dividends
There is a tradeoff between high dividends and long-term earnings growth. Obviously the more cash a company pays out to its shareholders, the less it has to fund growth without either issuing more debt or more equity. That can be a dangerous game to play.
However, it’s not uncommon for solid businesses to distribute more and more of their earnings to shareholders through higher dividends as they mature. Bigger companies have less growth opportunities and compete in crowded markets, so they plow back less of their earnings into the company and more into your wallet.
But if a company is going to increase its dividend over time, it needs to grow earnings and cash flow to do so. This is why it’s important to know a company’s sustainable growth rate.
The sustainable growth rate is the maximum growth rate that a company can sustain without having to issue more debt or more equity. It is calculated as:
(1 – Payout Ratio) x Return on Equity
For example, say a company pays out 30% of its earnings in dividends and its ROE is 15%. Its sustainable growth rate would be 10.5% (.70 x .15). Clearly the lower the payout ratio and higher the ROE, the higher the sustainable growth rate. That means higher future cash flow growth and, likely, higher future dividend growth.
The Tortoise vs. the Hare
Imagine that you have the choice to invest between two different stocks for the next decade – Tortoise Corp or Hare Corp.
Fictional Tortoise Corp currently has a relatively low payout ratio, a solid balance sheet and a high sustainable growth rate. It trades for $50 per share and currently pays a dividend of $1.25 for a yield of 2.5%. It earned $3.75 per share this year, so its payout ratio is currently 33%. Its return on equity is 20%. Let’s assume that over the next 10 years, Tortoise Corp increases its payout ratio linearly to 67%.
Meanwhile, Hare Corp also trades for $50 today and earned $3.75 per share this year. But it pays out 90% of its earnings as a dividend for a yield of 6.8%. Its ROE is 10%. Since Hare Corp already pays out so much of its earnings in dividends, it doesn’t raise its payout ratio. It also doesn’t have much to invest in future growth, so its earnings grow at a much slower rate.
Investors focused solely on current yield would jump into Hare Corp for its higher dividend. But the stronger total returns will very likely come from Tortoise Corp.
In fact, both companies in this scenario will pay out about the same amount in total dividends over the next decade (ignoring the time value of money). But by year 10, Tortoise Corp will have more than double the earnings of Hare Corp and a higher book value too. Slow and steady wins the race.
Clearly, a company’s dividend growth potential should be very important for long-term investors.
The Bottom Line
Beware the siren call of high yield stocks. A big yield may look attractive at first glance, but investors are usually much better off focusing on a company’s dividend growth potential.
That is one reason we developed a portfolio that I am managing called Zacks Income Plus.
The other reason is that very few years are like 2013 with a wonderfully calm, steady upward swing.
Already we’re seeing a lot more market volatility this year, and many investors prefer a smoother path to outperforming the S&P 500. So our Income Plus Investor is designed to combine high-paying dividends (more than twice the average for S&P stocks) with dynamic potential growth. Today, 9 of our stocks are gaining well into the double-digits and the ends of those booms are not yet in sight.
Would you like to find out more about this portfolio? Click below and you’ll also see two new moves I am exploring right now. One is a currently undervalued real estate investment trust that has increased its dividend every year since 2010 at a +13% compound annual growth rate. Another is a major beverage stock with great cash flow that has also rewarded its thirsty shareholders with consistently bigger dividend payments.
Find out more about Income Plus Investor. 
Todd Bunton, CFA is Zacks Growth & Income Strategist. He manages our Income Plus Investor, which detects companies that not only pay high dividends but are also likely to see exceptional price appreciation.
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