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.
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 midsize bank New York Community Bancorp (NYSE: NYB ) for instance. Over the past 12 months, the company has paid out 83% of its income in dividends; over the past three years it has paid out an average of 91% 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 growthy days are in the past.
A laser-focus on dividend yields also means that investors may not be comparing potential investments on an apples-to-apples basis.
At first glance, the 2.9% dividend yield for fellow bank PNC Financial Services (NYSE: PNC ) may look puny next to NYCB's heftier 8.4% dividend, but over the past 12 months, PNC has paid out a mere 11% of its income in the form of dividends. But what would happen if PNC was more like NYCB and paid out, say, 90% of its income? That 2.9% yield suddenly jumps to a huge 13.1%.
Could PNC actually pull that off? The bank is in much better shape than, say, Bank of America (NYSE: BAC ) and Citigroup (NYSE: C ) , but banks in general are being pretty mindful of their capital right now and most aren't going to be willing to promise investors a dividend that requires a 90% payout. That said, the bank paid $2.61 per share in dividends in 2008 and over the past 12 months, PNC has earned close to triple the earnings per share that it did in 2008. So while a 13% dividend may be too much to expect, it's clear that PNC could easily pay a much larger dividend than it does today.
It may seem odd to stack PNC's theoretical 13% payout against NYCB's actual 8.4% 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 reinvest some of their earnings for future growth, buy back shares, or hang onto some extra cash. That doesn't mean 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.
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