Dividends are a hot topic for many investors right now. The turmoil of the financial meltdown is still fresh and the tangibility of a quarterly cash payout hits the spot like a cool glass of lemonade on a midsummer day in the desert.
Not surprisingly, investors have been drawn to companies that feature massive dividend yields. And why not? If you're going to go for dividends, why not go big.
But the catch is that many -- if not most -- of the companies with huge dividend yields get those yields by paying out nearly all, if not all, of their income through those dividends. Take copper miner Southern Copper (NYSE: SCCO ) for instance. Over the past 12 months, the company has paid out 83% of its income in dividends and over the past three years has paid out an average of 109% of earnings.
By focusing on the dividend yield alone, investors can end up overlooking the bigger picture. A dividend-paying company with a high payout ratio may have a tougher time maintaining its payout if it hits a speed bump. It may also have little capital left behind to reinvest in the business and might be forced to load up on debt or sell new shares if it wants to grow. Or, it may simply be admitting that its days of growth are in the past.
A laser-like focus on dividend yields also means that investors may not be comparing potential investments on an apples-to-apples basis.
At first glance, the dividend yield of 2.9% for Southern Copper foe Freeport-McMoRan (NYSE: FCX ) may not look very generous next to Southern Copper's heftier 8.8% dividend, but over the past 12 months Freeport has paid out a mere 14% of its income in the form of dividends. But what would happen if Freeport was more like Southern Copper and paid out, say, 90% of its income? That 2.9% yield suddenly jumps to a huge 16.9%.
Let's not get too ahead of ourselves here. Mining is not the kind of smooth, dependable business that lends itself well to creating a stellar long-term dividend track record, like a dividend aristocrat such as Procter & Gamble (NYSE: PG ) . That means that even if Freeport starts paying out much more of its earnings in dividends, it may have to drastically cut back when market conditions change -- which Southern Copper has been known to do. And while Freeport could take such an approach, the fact that it hasn't decided to may reflect management's desire to maintain a more conservative balance sheet. As of June 30, Freeport had $4.4 billion in cash to Southern Copper's $1.7 billion.
Now it may seem like on odd comparison to stack Freeport's theoretical 16.9% payout against Southern Copper's actual 8.8% yield. But, this is meant as a thought exercise and a reminder that a dividend yield is only part of the story. Many really great companies have the earnings power to pay truly massive dividends, but simply choose to either reinvest some of their earnings for future growth, buy back shares, or hang onto some extra cash. That doesn't mean that you should consistently pass up big dividends for smaller ones, but it does mean that you may miss out on some really great companies if the one and only stop in your research is to ogle a stock's yield.