Many investors love to invest based on high dividend yield alone. Are you one of them?

Some people think that dividend stocks are safer, but is it true?

In this article, I will be sharing some of the misconceptions we need to be wary of when investing in dividend stocks.

I will be answering some of the misconceptions like: are investing in “blue-chips”/dividend stocks safer or is investing in high dividend yield stocks good?

Are Dividend Stocks and So-called “Blue-Chips” Safer?

First, let me get it out of the way: stocks are not inherently safer or riskier because they are dividend stocks or “blue-chips”.

I personally view risk as a permanent loss of capital. What is your view of risks?

A dividend stock or “blue-chip” can be risky if the business is in a perpetual decline or if the management is destroying the value of the company through bad management (and as a result, the company has to cut dividends). And not only that, if the business does not perform well in the future, capital losses on top of dividend cuts are bound to come as well.

Essentially, dividend stocks or “blue-chips” can be very risky if we do not understand them well and as a result, we might be buying into a company whose future is going to become worst over time and their share price will reflect that. This is the definition of “value trap” – buying into a company whose shares have fallen and the share price falls further because the business did not improve for the foreseeable future.

Does High Dividend Yield Means It’s A Good Sign?

High dividend yield companies can be a potential sign of a “value trap”.

Remember, the dividend yield is calculated by taking the company’s latest dividends dividing it by the company’s current share price. Sometimes, a company’s share price may fall a lot and as a result, the dividend yield goes up.

But remember, the dividend yield is a lagging indicator. If the company’s business performance continues to do worse into the future, the company’s share price may fall further and the dividend may even be cut or eliminated entirely. A company is usually cheap for a reason.

Buying a company’s stock just because they have a high dividend yield without understanding the business and the future of the business can be a recipe for disaster.

So, What To Look Out For When Investing in Dividend Stocks?

Many investors like dividend-paying companies because of their ability to generate income on top of potential capital gains. But one thing to note is that both dividends and retained earnings technically should come from the same place, which is net income. Without sufficient net income, a company will need to cut or eliminate dividends, or else, it will not be sustainable.

Hence, when looking at dividend-paying companies, I believe that ultimately the key thing to note and look out for is whether the company’s business can sustain and grow over the long run or not. Because remember, sustainable dividends come from the business’s ability to generate sustainable returns on its equity over the long run.

To estimate how much more the company dividend can grow, it can be useful to use the sustainable growth rate formula to estimate it. Take the company’s ROE and multiplying it by the company’s retention rate (1 – dividend payout ratio). For example, if a company has an ROE of 15% and a dividend payout ratio of 0.5, that means that the company still has 15% x (1 – 0.5) = 7.5% more room to grow its dividends based on the sustainable growth rate formula.

When analyzing dividend stocks, look at it from the point of view of us becoming a business owner in that business. What do we want to see? We want to see whether the company has good management that has executed well in the past. We want to see their performance so far in terms of revenue growth, earnings, ROE, etc. We want to see if they are in any danger with regard to their leverage. We also want to see if the future of the company looks brighter than it is today or it is not. Among others.

In summary, when looking at dividend stocks, do not have the illusion that because they have a high dividend yield or it is a “blue-chip” company, it is safe.

Image source: Google

Safety comes from the business and managerial strength and us knowing what we invest in. Not simply whether they have a high dividend yield or it is a “blue-chip” company. Especially not simply because they have a high dividend yield. Just look at First Reit stock above, when it fell to around 90 cents, the dividend yield was getting higher – but as of now, it can be seen that they are all just an illusion because the business continues to perform poorly (a classic definition in my view, of a value trap at 90 cents).

Disclaimer:

The information provided is for educational and general information purposes only and is not intended to be personalized investment or financial advice. We make no promises as to the accuracy or usefulness of the information we present.

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