Please ensure Javascript is enabled for purposes of website accessibility

About to Buy High-Yield Dividend Stocks? Read This First

By Keith Speights – May 28, 2017 at 6:44AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Three questions to ask before buying dividend stocks with really high yields.

Who doesn't like a stock that pays you to own it? That's exactly what dividend stocks do. It only makes sense that investors would like high-yield dividend stocks, because they pay even more to own them.

There are some potential pitfalls with investing in some high-yield dividend stocks, though. Here are three questions to ask before you take the plunge. 

A smiling man holds his hand up to word "dividends"

Image source: Getty Images.

1. Why is the stock's yield so high?

If a stock has a sky-high dividend yield, it's smart to know why. Because the yield is a simple ratio of the annual dividend divided by the stock price and then multiplying by 100, there are two basic reasons it could be high. First, the dividends paid could be really strong. Second, the stock price could be really low.

Frontier Communications (FTR) is a textbook case of the reason you should ask why a stock's yield is high. The telecommunications company has an incredibly high dividend yield of 11.68%. Why? The following chart tells the story.

FTR Chart

FTR data by YCharts

Frontier Communications stock has been steadily falling over the past 12 months, as the company has lost customers and, thus, revenue. For most of that period, the dividend held steady, pushing the yield higher and higher as the stock fell.

Investors who bought Frontier hoping to make a lot of money from the high yield were in for a rude awakening: Frontier slashed its dividend in May. Any investor who asked why Frontier Communications' yield was so high wouldn't have been caught off guard by the dividend cut. 

2. Is the dividend sustainable?

The first question leads to the natural follow-up: Is the dividend sustainable? In Frontier Communication's case, the answer was no. But that's not the situation for every high-yield dividend stock.

Kohl's Corporation (KSS 2.02%), for example, boasts an attractive yield of 5.8%. It's high because the stock price has fallen but also because the company has increased its dividend. Can Kohl's keep the dividends flowing at current levels?

One quick way to spot a potential problem with dividend sustainability is to check out the stock's dividend payout ratio. If the ratio is above 100%, it means the company is spending more to fund its dividend program than it's making in profit. That can't continue indefinitely.

The company's payout ratio currently stands at 64%. That's not bad. It means the retailer's earnings are still well above its dividend payouts.

What if the payout ratio had been 100% or greater? That wouldn't necessarily paint a gloomy picture. If the stock's payout ratio is high, also look at the company's cash flow. A strong cash flow can allow a company to sustain a dividend even when it's spending more on dividend payouts than it's earning. 

3. What are the stock's overall prospects?

It's great to receive a dividend. However, if the stock really tanks, your losses could make any dividend payments irrelevant. On the other hand, great future prospects could mitigate concerns about a high-yield dividend stock's high payout ratio. That's why you definitely need to evaluate the overall prospects for the stock.

Look at Omega Healthcare Investors (OHI -2.08%). The healthcare real estate investment trust (REIT) has a great yield of 7.51%, but its payout ratio stands at 118%. In the first quarter, Omega reported combined cash flow from operating and investing activities of $130.3 million. That was a little higher than the $122.3 million the company spent to fund its dividend program during the quarter.

At first glance, you might suspect that Omega's high dividend yield could be in jeopardy. However, the company increased its dividend payout in November and has done so for 18 consecutive quarters. It has been able to do so because its growth prospects are strong.

Omega Healthcare Investors provides financing and capital to the long-term healthcare industry. With the baby boomer generation getting older, the demand for the skilled-nursing and assisted-living properties that Omega specializes in should increase. It's not surprising, therefore, that Wall Street analysts project the company will grow earnings by an average annual rate of nearly 16% over the next five years. 

Keith Speights has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.