High Dividend Yield: Risks and Considerations for Investors
Investors often find themselves drawn to stocks offering extraordinary dividend yields, with recent history suggesting that most companies do not pay such large dividends. When facing a stock with a 3.35 dividend on a 14 stock price, it is crucial to scrutinize this opportunity thoroughly. This article aims to guide investors through the important considerations before making a purchase to ensure the investment is worthwhile.
Initial Scrutiny
Firstly, the source of the information is critical. Without knowing the company involved, it is difficult to provide a comprehensive analysis. However, if you have encountered such a scenario or wish to understand more, you need to employ the same level of caution as if you were engaged in a securities investigation. A high dividend yield might initially seem promising, but often, it comes with underlying risks.
Company Evaluation
To evaluate a company that offers a significant dividend yield, start with the company's debt levels and cash flows. These metrics are key to determining if the company can sustain such payments. Companies with substantial debt to cover dividends are typically issuing these dividends out of necessity, rather than sound financial planning. It is essential that dividends are paid from regular cash flows, not by incurring additional debt or engaging in accounting maneuvers.
Moreover, it’s important to consider whether the dividend is a regular payment or a special dividend. Special dividends are often declared due to specific one-time circumstances and should be approached with caution. Investors must inquire into the reasons behind the distribution, ensuring they align with the company's long-term strategic objectives.
Risk Analysis for Long-Term Investment
When assessing the stock as a long-term investment, a 24% annual dividend yield is a clear warning sign. Typically, such yields indicate that the company is struggling to sustain the dividend. For instance, Apple (AAPL) has a relatively low payout ratio of 25%, signifying that a fraction of its net income is allocated to dividends, making it a sustainable and regular payment.
A high dividend yield today might indicate that the company will soon cut dividends. Therefore, it is advisable to look for any recent disclosures regarding dividend policies and payments. Additionally, consider the company's stock price and whether it logically matches the high dividend yield. If the company's current stock price is at 14 and offers a 24% yield, it is highly likely that this high yield reflects either a suspended future dividend payment or an embedded assumption of declining dividends.
Utilizing Dividend Metrics
To further evaluate the sustainability of the dividend, use the dividend coverage ratio or payout ratio. For instance, Apple's (AAPL) Yahoo Finance statistics tab indicates that the payout ratio is 25%, suggesting that a quarter of its net income is paid out as dividends, which is generally sustainable.
Dividend Coverage Ratio: Estimate the sustainability of the dividend by analyzing the company's ability to cover this payout from its operating cash flows. A healthy ratio indicates a lower risk of dividend cuts.
Dividend Discount Model: Consider the relationship between the stock price and dividend using the dividend discount model. This equation (Stock price Dividend / cost of capital) helps you understand how the stock price and dividend yield impact the overall investment risk.
For the given example, using the formula:
14 3.35 / cost of capital
It yields a cost of capital of 24%. A high cost of capital suggests a risky investment. Alternatively, assuming a more reasonable cost of capital of 8%, you can calculate the implied dividend growth rate, estimating that the stock price assumes the dividend will decline at an annual rate of about 16%.
In summary, while a high dividend yield may appear attractive, it is imperative to conduct extensive research to ascertain the sustainability and security of the investment. Investors should carefully evaluate the company's financial health, the nature of the dividend, and the overall risk associated with the stock before making a purchasing decision.