These days, dividend stocks reign supreme for many investors. Given how many people need both growth and income from their portfolios, the lack of good income-producing alternatives make stocks the natural choice -- and for all practical purposes, just about the only choice right now.
But any time you start judging stocks by a single measure, you run the risk of getting misleading information. Today, I want to take a simple look at another way of measuring how productive the stocks in the Dow Jones Industrial Average (INDEX: ^DJI ) are, in an effort to show the contrast between the top dividend-yielding stocks in the Dow versus those that arguably have the most income potential.
Going beyond the simple
Picking stocks based on dividend yield is the easiest thing in the world to do. With the Dow, there's even a group of investors willing to do your work for you, thanks to the famous Dogs of the Dow strategy. Every year, many investors follow the mechanical approach of taking the top-yielding Dow stocks and investing in them for the next year. That strategy has had mixed success, but it certainly has the benefit of being simple to follow.
Even if you don't choose such a rigid approach, though, paying attention to dividends is a smart move for a Dow stock investor. After all, the Dow's companies are all giants in their industries, leaders that have proved their ability to remain profitable through good times and bad and to reward their shareholders throughout all sorts of conditions.
But by adding just one more equally simple measure of a stock's success, you can get a much broader picture of the Dow than you get from dividends alone.
Bringing in earnings
Dividend yields show you only part of a company's situation -- the part that comes back directly to shareholders. But while some would argue that the cold, hard cash that comes back to shareholders is the only true way to measure success, you can't ignore that many companies have income-generating power that goes well beyond the portion they pay out to investors.
One simple way to measure that earning potential in a way that's compatible with the dividend yield is through a measure called the earnings yield. If you divided a stock's earnings by its share price, you'll get a figure that's directly comparable to the dividend yield -- and looking at those two figures side by side gives you some insight beyond mere dividends.
A whole new ballgame
The most interesting thing that earnings yields reveal about the Dow's dividend stocks is that many of the top yielders in the Dow don't have great earnings yields. AT&T (NYSE: T ) and Verizon actually have earnings yields well below their dividends, stuck in the 2% range. Granted, AT&T's earnings are depressed from a big one-time charge related to its failed T-Mobile merger. The telecoms are also notorious for having earnings that don't necessarily reflect their actual cash flows, making higher dividend yields not only possible but also sustainable.
Similarly, drug companies Merck (NYSE: MRK ) and Pfizer have nice dividend yields, but their earnings yields are only a bit higher at around 5%. It's even possible that those earnings could come down in future years as income from blockbuster drugs declines after they go off-patent.
At the other end of the spectrum, though, are Chevron (NYSE: CVX ) , Hewlett-Packard (NYSE: HPQ ) , and JPMorgan Chase, each of which sports earnings yields of more than 10%. Yet none of them has a yield above 3%, showing that these companies are keeping more of their capital, either to reinvest in their businesses or for alternative purposes such as share buybacks. Chevron has benefited from high oil prices and could be concerned that current income levels aren't guaranteed for the long run. HP, on the other hand, has seen its shares plunge in response to leadership crises that have lasted for years, setting up a possible rebound if new CEO Meg Whitman turns things around.
Get what you want
Picking high-yielding Dow stocks seems like a smart move, but it isn't necessarily your best choice. By incorporating earnings yields into your analysis, you can get a better picture of companies' overall situation without making things much more complicated.
Go beyond dividends to find the right stocks for your portfolio. The Motley Fool's latest special report on retirement will show you the way, with three promising stock picks for long-term investors. Don't wait; get your free report today while it's still available.