Don’t let a stock’s dividend yield fool you…
Just because a stock yields 8%-plus, that doesn’t make it a good income investment.
Many investors find a company with a high yield, and dive headfirst into the stock. Snapping up shares without a second thought.
But a juicy dividend yield doesn’t tell the whole story. There are a few key traits that you need to look for to make sure that something bad isn’t lurking beneath the surface.
First, you want to make sure that a company isn’t boosting their dividend yield by paying out more than it takes in.
Imagine if every month you paid $5,000 in bills, but only brought in $4,500 a month. You might be able to sustain that for a while, but eventually the shortfall every month will cripple your financial situation.
Same thing with businesses. A company can’t pay out more than it takes in — at least not for long.
A quick way to identify if a firm’s dividend yield is sustainable is by looking at its payout ratio. A payout ratio of 100% means a company is paying out exactly what it brings in.
It’s breaking even.
While this might sound good for shareholders, it doesn’t give the company much wiggle room should it have a rough couple of quarters or a bad year or two.
You want a company to have enough in earnings to pay shareholders as well as pay down debts, and reinvest back into the business. The sweet spot for most companies is a payout ratio of around 40% to 60%.
Too low, and you probably aren’t getting a good yield. Too high, and the payout might be on thin ice (especially if earnings slide). Right in the middle leaves wiggle room for downturns — as well as future hikes.
Keep in mind, some industries commonly pay out more.
Real estate investment trusts (REITs) and master limited partnerships (MLPs) must distribute at least 90% of their taxable income to maintain their federal tax-exempt status.
But this is just the first step for finding a perfect dividend stock. You still need to dig deeper and look at other critical financial metrics.
So keep an eye out on my next email — I’ll give you the rest of the details in Part II.
In the meantime, I have something to keep you busy. It’s my Income Manifesto — an e-book I wrote that covers everything you need to know about dividend investing.
In the book, I cover:
Get my Income Manifest here (absolutely free)!
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Monday Morning Paydays