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:

• Why everyone should consider investing in dividend stocks.
• How dividend stocks outperform the market with less risk.
• Common misconceptions about income stocks.
• My 3 favorite dividend-paying stocks right now.

Get my Income Manifest here (absolutely free)!

And if you haven’t yet, make sure to add [email protected] to your address book or your safe list.

You don’t want to miss any of the great income stocks and traders we’ll be sending your way.

Roger Scott

Monday Morning Paydays