Some investors buy high-dividend stocks for high current income, on the assumption that they have found a bargain overlooked by others. This is a dangerous strategy because no stock stays under the radar for long and if others are not buying such an obvious bargain, there must be hidden reasons which the buyer either does not see or does not fully understand.
What's A High Dividend?
The dollar amount of a dividend does not mean much until it is compared to the current stock price. Investors use dividend yields to compare dividends. A dividend yield is the amount of the current annual dividend divided by the current stock price. For example: A $60 stock paying a $2 dividend has a dividend yield of 3 percent, whereas a $20 stock paying a $1 dividend has a dividend yield of 5 percent. Dividend yield shows how much income an investor should expect on an investment if he were to buy at the current price.
Dividend Yield Variables
Every component in the dividend yield ratio is variable: the dividend amount, current stock price, and resulting yield all can and do change. If the dividend remains the same, an increase in the yield is the function of a falling stock price; if the dividend is increased, investors are likely to bid up the stock price, so the yield would remain more or less the same.
The biggest risk in buying high-dividend stocks is a falling stock price. A stock’s price reflects investor sentiment. If a stock has an above average dividend, it pays to find out why before buying it.
Risk of Dividend Cut
Dividends are corporate profits distributed to shareholders. If a company is not generating enough profits to cover the dividend, or is incurring losses, the current dividend is unsustainable and is at the risk of being cut or eliminated. Dividend yield is based on past dividends and does not predict the future. A falling stock price may indicate that investors are reluctant to buy for fear of a dividend cut.
Some low-priced high-dividend stocks may also sport low price-to-earnings (P/E) ratios, adding to a buyer’s false sense of security. P/E -- the ratio of current stock price to current earnings per share (EPS) -- is a widely used measure of stock valuation that shows how much an investor would pay for a dollar of earnings. A low P/E suggests a low valuation, and a high dividend looks like a nice bonus. The danger here is that if a company earns less, or loses money, its EPS will go down, or turn into losses, and the low P/E will go up or disappear.
If an investor buys a high-dividend stock and the dividend is cut or eliminated because the company is losing money, he will suffer the double loss of no dividend income and a falling stock price.
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Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.