Last Updated on December 23, 2020 by Oddmund Groette
After reading this article you’ll learn the following:
A good dividend yield is neither high nor low. Research shows the lowest and highest quintiles of dividend-paying stocks underperform those in the 2-4 quintiles.
A dividend yield is a percentage that expresses the annual dividend with respect to its stock price. For better understanding, let’s assume that a dividend is neither raised nor dropped, the yield will rise if the price of the stock were to fall. In the case where the value of the stock rises, the yield will fall. This understanding goes a long way in realizing what really is the dividend yield.
In general new companies that are still growing but are comparatively small, don’t pay high dividends as much as mature companies do. Also, mature companies that aren’t growing too fast tend to pay high dividend yields. These two statements show the direct relation that dividend yield has with the growth of the company.
There is a good reason why experienced investors say no to chase after high yields when investing in dividend stocks. The higher dividend a company is paying, the less it is investing in itself. Moreover, dividend yield does not provide enough information. A high yield may have a lower stock price and reap the same benefits as the high-priced stock with a lower dividend yield.
In fact, experts generally suggest a yield that isn’t too high or too low is the best:
What is the best dividend yield?
Research by Hartford Funds, for example, in a study called The Power of Dividends, shows that the lowest and highest quintiles underperform the 2-4 quintiles, with the fifth being the worst. And which yield group is in the fifth quintile? It’s the 20% highest-yielding stocks. This, to make a generalization, is not the group of stocks where you want to invest.
Likewise, in quintile number one, the group with the 20% lowest-yielding stocks, you would not look for dividend stocks. They are the second worst-performing quintile. The best dividend stocks are the ones that yield closest to the average, in quintile 2-4.
Why? Let’s take a look.
A high dividend yield does provide an attractive number that attracts a lot of investors. But the ones who are trying to construct a robust portfolio have a lot depending on dividend yields since it directly depends on the growth of the company. Here’s why a high dividend is not always a good deal.
Not every time a high yield is a good sign. Yes, dividends do represent generosity on the company’s part for the trust an investor is putting in the company but equally high yields represent potential risks.
First, a company pays dividends out of its net income, a chunk of which is kept aside as retained earnings, meant to be invested in the company’s growth for its current and future project with potentially high returns. So like we have said before, every penny that a company is paying in dividends is every penny they are not investing in future growth.
Moreover, a high dividend yield mostly occurs when the share price falls. Why does the share price go down? It goes down because the market discounts future problems and estimated deteriorating earnings. A perfect example of this is the drop in Altria from 75 in mid-2017 to below 40 for most of 2020. However, the earnings have not fallen and the dividend is not cut, but somehow the market discounts a bleak future. It’s up to you as a dividend investor if you believe this is for real or a good buying opportunity. (We in RationalThinking believe the stock offers good value and have included the stock in our Unethical Portfolio.)
Dividend yield misconceptions
Many investors in the run for chasing high yields forget about the stock price. A high valued stock with low dividend yield may benefit the same as a low valued stock with a high yield. For someone looking forward to saving for long-term goals needs to focus on total returns, the stock’s valuation, and the payout ratio.
It is troubling when investors focus on just the stocks’ dividend yield, thinking of them as bonds. In fixed-income investments like bonds, the yield is the return. However, it is not the same for a dividend stock. Moreover, dividend payout is not compulsory for a company to pay, it is more like a distribution.
It is highly recommended for investors not to evaluate the data based on just its dividend yield. The data could be old or based on misleading information. There are instances of many companies that have a very high yield because their stock is falling. If a company goes through secular decline, there’s a high possibility that they cut down the amount on the dividends or even eliminate them completely.
In fact, investors should take extra caution while analyzing a company in distress with higher than normal dividend yields, the reason being that stock price is the denominator on the estimated future earnings.
For long-term return, an investor should look into the company’s growth, instead of just focusing on the dividend value. Evidence suggests going after an average yield- not too high, not too low. An experienced investor knows the value of total return and inclines towards compounding. Investing back into the company with the dividend amount increases their total return. Looking into dividend yield is important and at times beneficial, however, it is always smart to dig a little deeper.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.