Dividend-focused investors often prefer stocks with higher yields, which makes complete sense. But a high yield alone isn't a good enough reason to buy a stock. You need to think about high-yield dividend stocks a little deeper than that. Here are five facts that you need to know to make sure the high-yield stocks you buy are the best options for your portfolio.
1. High yields can signal value
A lot of investors focus on valuation tools like the price-to-earnings and price-to-book value ratios. Those are important tools that should be used in the valuation process. But a high yield can also signal that a stock is relatively cheap. All you need to do is look at the yield relative to its historical trends. If a stock's yield is at the high end of its yield history, it's probably worth taking a closer look.
For example, ExxonMobil Corporation's (XOM -1.58%) yield is currently around 4.1%. That's near the highest levels since the mid-1990s. There are reasons for this and investors need to dig into the facts before hitting the buy button. However, this oil giant is financially strong and the dividend looks solid. This appears to be a situation where a great company is simply working through a tough time. While short-term investors are dumping out, and pushing the yield up toward historically high levels, long-term investors have an opportunity to jump aboard.
2. A high yield can signal trouble
While a high yield can highlight opportunity, it can also signal that a company's troubles are so bad that a dividend cut is in the cards. Which is why you have to do your homework before buying a high-yield dividend stock. A great recent example of this was Plains All American Pipeline LP (PAA -0.58%).
Between 2015 and early 2016, the midstream master limited partnership's yield rocketed from around 5% to over 16%! Two distribution cuts later, the yield is down to around 6%. The warning sign here was weak distribution coverage, with the partnership paying out more cash in distributions than it was generating to cover them. But there was more going on: A downturn in the energy space was limiting access to the capital markets for most midstream companies at the time, and Plains' debt levels were at historically high levels. That's a toxic combination still being witnessed throughout the midstream space. To put it simply, Plains All American had little flexibility to deal with a difficult period and was forced to cut its distribution.
Exxon's financial and industry positions, by comparison, are rock solid. So while a high yield can signal opportunity, it can also be a warning that the dividend is at risk of being cut. To figure out what is going on, you need to dig a little into the story behind the yield.
3. High yields are worth the effort
With that quick caveat in mind, it's important to remember just how valuable dividends are over time. Since 1871, roughly half of the S&P 500's return is attributable to dividends. The other half is attributable to price appreciation. Let that sink in for a moment -- dividends make up a huge portion of the market's total return over time.
But think about this concept in a different way using the rule of 72. By dividing 72 by a stock's yield, you can get a rough estimate of how long it would take you to double your money if you reinvest the dividend and assume the stock price stays the same. In the case of Exxon, it would take around 17.5 years to double your money. That's a long time to wait, but if you can find a stock yielding 6% that's out of favor for what appear to be temporary reasons, the number drops to just 12 years. At 7% you could double your money in roughly a decade. These aren't unusual yields for real estate investment trusts (REITs) and limited partnerships, and can occasionally be found in other sectors during market downturns. And remember, this calculation assumes that stock prices don't change. Price appreciation would add to your returns over time.
4. Dividends don't come from earnings
Switching gears a little bit, there's a fundamental issue about where dividends come from that investors need to understand. Very often you'll see a stock's payout ratio highlighted. This metric effectively takes dividend per share and divides it by earnings per share to tell investors how much of a company's earnings are getting distributed as dividends. It's a valuable number to know, with lower percentages signaling very safe dividends. However, dividends don't come from earnings; they come from cash flow.
Plains All American is an interesting example on this front because distribution coverage in the limited partnership space is calculated based on distributable cash flow. This is because midstream partnerships tend to have high levels of depreciation, a noncash charge that depresses earnings per share. The same is true in the REIT space, where the funds from operations, or FFO, payout ratio is the metric to watch. It also explains why companies can sometimes have payout ratios of more than 100% while still managing to pay their dividend, particularly when one-time noncash charges enter the picture.
At the end of the day, you simply need to be cognizant of the fact that dividend payments come out of cash flow and impact the cash flow statement. This means that a high payout ratio may not be as big a deal as it first seems. You need to dig deeper to find out if the dividend is truly at risk.
5. Dividend growth matters
It's easy to love a high yield, but you can't forget about dividend growth. Inflation, or the rise in prices over time, eats into the purchasing power of money. If you buy a stock with a big yield, but no dividend growth, the buying power of the income you generate will actually decrease as the years go by. Since inflation grows at around 3% a year, historically speaking, it's a good idea to favor investments that can grow distributions by at least that amount, on average.
If you can find higher growth rates, you'll be even better off. Take Enterprise Products Partners LP (EPD -0.18%), one of the largest, most diversified, and fiscally conservative midstream players in North America. It has historically grown its distribution by mid-single digits, leading the distribution to expand 65% over the past decade. Smaller, but similarly conservative, Magellan Midstream Partners LP (MMP) has historically grown its dividend at a rate in the high single digits to low double digits. Over the past decade, its dividend has well more than doubled. Sometimes, owning a stock with a lower yield coupled with a higher dividend growth rate is better than buying the stock with the highest yield.
Of course, these five facts aren't all you need to know about dividend investing. But they provide an important grounding from which to start the process. Now that you know them, it's time to go back and look at your portfolio to make sure you have the best dividend stocks and haven't inadvertently drifted into higher-risk investments that won't be as rewarding over time as you had originally hoped. After that, you can apply this knowledge to new purchases to ensure your portfolio is filled with great, high-yield investment opportunities.