High Dividend Yield isn't Everything

One is often tempted to add a stock which is currently yielding very high compared to the peers. Using a high dividend yield as the only criteria can be quite disastrous. You have to remember that you are buying into a piece of business and ensure that the business has a future. One of the important criteria to combine with high dividend yield is dividend payout ratio. A dividend payout ratio below 60% means that the high dividend yield might be sustainable over the next years even if earnings were to come under pressure. One must remember that there is always some reason behind stock prices moving down so much pushing the dividend yields higher. My biggest concern is often that there might be an expectation of a dividend cut. If that happens, out entry yield will be cut not to mention the stock price would have already moved into negative territory making it tough to get out even on break even. A thorough analysis of past financial statements is an absolute must for these companies. Competitive forces in the market also need to be studied.

Market often overreacts on bad news. This often creates good entry opportunities to enter into good solid businesses at a discount. The key point is the business being solid. Recently I have been analyzing RSA Insurance. It had been facing some headwinds with its operations in Ireland. A 6% yield was looking attractive to me as I don’t have to pay taxes in UK. I finally decided not to buy the stock as there seemed to be so much uncertainty about the future of the business. So much that recently the CEO stepped down. This was perceived as really bad news by the market and stock sold off 18.76%! Now the dividend yield has been pushed higher to 7.60%. Obviously, in this case just looking at 6% yield and investing would have been disastrous in the short term. It is still too early to say what will be happening with RSA Insurance in the long term. May be the market has overreacted providing a good entry point.

To summarize, high dividend yield is not everything. Look at other parameters like payout ratio and competitiveness of the business to gauge sustainability.