Don't be blinded by a huge dividend yield. Image source: Getty Images.
Believe it or not, high-yield dividend stocks -- those that pay out 6%, 10%, or more -- often stand a good chance of losing you money. In fact, in some situations, a generous dividend can be a major red flag. So before you plunk $10,000 into a stock that you expect will pay you $1,000 per year, consider these reasons why high-yield stocks can be dangerous.
1. That income is not guaranteed
First off, understand that high-yield dividend income, just like any dividend income, is not guaranteed. No dividend-paying company wants to alienate shareholders by slashing or eliminating its dividend, but it nonetheless happens sometimes.
You can generally rely on a company to meet its dividend-payment obligations, but if a company is in distress, then that dividend isn't secure. In 2015, 394 publicly traded companies cut their dividends, per S&P Dow Jones Indices data. In 2008 and 2009, during the financial crisis, even such stalwarts as General Electric, Dow Chemical, Bank of America, and General Motors cut their payouts. Many went on to reinstate or increase their dividends later, but that's far from guaranteed.
The good news is that it usually isn't a big surprise when a company cuts its dividend. There are warning signs, like when a company starts posting losses instead of gains, when its free cash flow turns negative or is very inconsistent, or when its business model no longer seems sustainable. National Oilwell Varco, a leading oilfield services company, slashed its dividend by a whopping 89% in April after its revenue and earnings took a big hit from depressed oil prices. When business drops off significantly, it can be hard to meet dividend obligations.
One metric to keep a close eye on is a company's payout ratio. A payout ratio is the percentage of its earnings that a company pays out in dividends. Anything close to or above 100% signals that the company is spending most or all of its earnings on dividends, which leaves little to no room for growth or margin of safety. Major casino operator Las Vegas Sands hasn't cut its dividend lately, but many think it might. Its payout ratio, for example, was recently 129%, thanks in part to weakness in the major gaming market of Macau, where it derives much of its revenue.
Keep in mind that in some industries, a high payout ratio is commonplace and not necessarily a warning sign. It's best to compare each company's payout ratio to those of its peers.
2. High-yield dividend stocks can be risky
When you see a stock with a steep dividend yield, go ahead and salivate, but be sure to assess the situation carefully. High-yield dividends can be risky. Remember the math they're based on: A dividend yield is calculated by taking the annual dividend amount (for example, four times the current quarterly dividend amount) and dividing it by the current stock price. Companies don't tend to change their dividend payments frequently or radically, but stock prices change all the time -- sometimes dramatically so. If the stock price falls and the dividend stays the same, then the yield will rise. This means that some stocks only have high dividend yields because the share price has plunged -- not because the company is especially generous. And a stock that has plunged has probably done so for a reason.
Consider TerraForm Power, for example. It recently sported an eye-popping dividend yield of 17.8%. That's certainly tempting, but a closer look reveals that its stock price has slid by more than 75% over the past year -- thus its yield has been pushed up into nosebleed territory.
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3. You can find better performers
Finally, don't be too quick to jump at the biggest yields you can find, because you can probably find better performers. High-yield dividends are often tied to slow-growing companies, so if you're itching to invest in companies with a chance of doubling or tripling within a few years, dividend payers aren't likely to fit that bill. Before a company can safely commit to a regular dividend payment, it must be confident in its future earnings, and it shouldn't need to invest all its money into growth opportunities. (Note: Slow and steady growers that pay dividends often outperform growth stocks.)
Even among dividend-paying stocks, the biggest dividend yield isn't always the best bet. Smaller yields can perform as well or better -- especially if they're growing faster. If you're looking at a 6% yield from a relatively fast-growing company and an 8% yield from a healthy but slow-growing company, the former might soon pay you more than the latter.
What to do
So what should you do? Well, don't write off high-yielding dividend stocks completely. Even the best dividend payers go through temporary downswings that elevate their yields for a while, presenting attractive investment opportunities. But the highest yields are not necessarily the best, and they can be tied to companies on shaky ground. Look for healthy and growing companies that pay dividends. Favor ones that are increasing their payouts significantly and that have more room to keep doing so. Then invest in them and aim to hang on for the long run.
