Don't Get Trapped by High Dividends - Analyst Blog

High-dividend stocks are always popular, and why not? When the market is fickle and when it's difficult to earn steadily from price movement of stocks, a high cash-dividend payer could be a good bet.

Cash dividends could return more than what you would have earned had you saved your money in a bank. But choosing a stock only on the basis of how high a dividend it pays may not always be a good idea. You may even find yourself trapped.

How Come?

Before selecting a dividend-stock, many investors' basic calculations focus primarily on dividend yield (annual dividend per share/stock's price per share) as this represents the percentage return on the invested amount.

Besides reflecting the percentage return, dividend yield also gives a fair idea of whether selecting a high dividend stock is actually a good decision. Generally, what would you do? If a company has been paying a high and steady dividend over a period of time, you will be convinced to buy its stock.

But when you make your mind to buy it, the good dividend history of the company would be definitely factored into its price. Now, if price of the stock has already appreciated, its dividend yield would trickle down, signaling you not to enter.

Then again, if the price remains stable, a high dividend will no doubt raise the ratio. But what if the denominator decreases? If the stock price decreases, it will also push up the dividend yield. Just when you've made up your mind to invest in a stock that has a high dividend yield, it may have lost much of its value on fundamental grounds. And if the weakness persists in the stock, its price could further depreciate even after you buy it.

So, if you buy a stock only depending on its high dividend or dividend yield, you may find the return insignificant or even incur a loss due to price depreciation.

What Else to Watch Out For?

Since a stock with a high yield could turn out to be a loser's pick, it's best you dig the fundamentals of the stock a little deeper.

First and foremost, weigh the odds of a company's poor performance. Persistent weak earnings or loss will not be able to cover regular dividend. So primarily, the dividend paying stock needs to have consistent positive earnings momentum to fill or fuel its capital base, which helps it to continue dividend payment.

Along with good earnings, strong sales numbers are also important, as weak sales will eventually drag down the bottom line. A foresight into the stock's future performance is also essential. Consensus earnings and sales estimates will help you to predict what lies ahead for the company.

The Pathfinder

A smart way to pick high dividend stocks is to analyze these from their earnings per share perspective. Otherwise, the risk of overlooking the real picture could be high.

We would suggest that you focus on the dividend payout ratio (annual dividend per share/annual earnings per share) instead of dividend yield. The lower the payout ratio, the higher will be the amount of earnings available to strengthen the company's cash position and vice versa. So, if a number of stocks pay similar dividends and if the yields for all look attractive, count only on the payout ratio to select your portfolio members.

Follow the Bigshots

Dividend yield and payout ratio apart, you can also take a look at the investment think tanks. The quantitative Zacks Rank, for example, will help you benefit from the power of institutional investors (mutual funds, pension plans, money managers, etc.).

The Zacks Rank is a proprietary quantitative model that uses trends in earnings estimate revisions and EPS surprises to classify stocks into five groups: #1 = Strong Buy, #2 = Buy, #3 = Hold, #4 = Sell and #5 = Strong Sell. The most widely used source of earnings estimates comes from brokerage or "sell-side" analysts.

These earnings estimates are also the key components in valuation models of most of the institutional investors. So, you can easily predict the sentiment of institutional investors on a particular stock.

Now, if you see that your target stock holds a Zacks #1 or #2 Rank, you can expect it to attract institutional investment, which will positively influence its price. At least, you don't have to worry about the price depreciation of this stock in the near term. Your expected dividend income in turn, will not be eclipsed by price depreciation.

(To learn more about the Zacks Rank, visit our Zacks Rank Education section.)

Attractive Dividend Stocks

Considering the above criteria, we think the following 3 stocks would be good additions to your portfolio as these are steady dividend earners with good overall return.

SK Telecom Co. Ltd. ( SKM ): The company provides wireless telecommunications services using code division multiple access (CDMA) and wide-band CDMA technologies.

Annual Dividend: $0.73 per sahre

Dividend Yield: 5.03%

Payout Ratio: 31%

Estimated 5-Years EPS Growth Rate: 7.9%

Zacks Rank: #2

Kayne Anderson Energy Development Company ( KED ): A principal investment firm specializing in energy investments. The firm prefers to invest in midstream energy companies.

Annual Dividend: $1.52 per share

Dividend Yield: 7.40%

Payout Ratio: 32%

Estimated 5-Years EPS Growth Rate: 3%

Zacks Rank: #2

PDL BioPharma, Inc. ( PDLI ): The company engages in the management of antibody humanization patents and royalty assets, which comprise Queen et al. patents and license agreements with various biotechnology and pharmaceutical companies.

Annual Dividend: $0.60 per share

Dividend Yield: 9.85%

Payout Ratio: 58%

Estimated 5-Years EPS Growth Rate: 14%

Zacks Rank: #2

Earn Less; Rest Assured

There are many more high-dividend stocks that you may add to your portfolio based on the above analysis for better returns as opposed to risk free investments. However, your first preference ought to be stocks offering non-stop dividend despite economic ups and downs.

Admittedly, many consistent dividend providers may not have attractive yields, but a steady income despite fluctuations in market sentiments could save you several sleepless nights.

Disclosure: The author has no positions in any stocks mentioned.

KAYNE ANDSN EGY ( KED ): Free Stock Analysis Report

PDL BIOPHARMA ( PDLI ): Free Stock Analysis Report

SK TELECOM CO ( SKM ): Free Stock Analysis Report

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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