Is Your Stock a Dog?

Investing in a blue-chip company with a high dividend yield is a great way to earn solid returns without taking on too much risk. Right? Um, wrong. A dividend yield can be a very misleading ratio, and when it comes to identifying stable companies that deliver regular and growing cash flows, you must look deeper than just a single metric.

The higher, the better?
A dividend yield is a ratio that measures a company's dividend divided by its share price. All things being constant, if the dividend goes up, the yield would climb as well-- and that might be a good thing. The yield, however, might also rise if the share price goes down. And that may not be a good thing.

For an example, let's look at Pfizer (NYSE:PFE). Today its yield is approximately 4.4%, as compared with 3.4% back in September. Is this a positive development? It's hard to say. A recent dividend hike was more than offset by a decline in the share price, because of the company's decision to discontinue research into a significant experimental drug. Investors would be unwise to invest on the yield issue alone, since a closer look at Pfizer's pipeline would be necessary before making an investment decision.

A tale of two companies
Another example might be useful. One titan of American industry has a yield of 3.4%, while an equally well-known blue chip has a yield of 2.3%. The titan delivered returns of 64% last year, while the blue chip delivered a more pedestrian 12%. Which stock would you prefer?

I hope your answer was: I need more information. General Motors (NYSE:GM), a.k.a. "the titan," does indeed offer a nice yield of 3.4%. It also offers declining sales, increasing health-care and pension costs, and a host of challenges too numerous to list here. Johnson & Johnson (NYSE:JNJ), on the other hand, offers a more humble yield of 2.3%. Yet J&J has offered 45 consecutive dividend increases, as well as a 10-year total return to shareholders of 12.6% per year. Few would disagree that J&J is by far the more stable company.

Have these dogs had their day?
The following table lists several companies that have relatively high yields.

You may recognize that these four companies are members of the Dogs of the Dow, a group of the 10 highest-yielding stocks in the Dow Jones Industrial Average that is compiled each year. Would investors be wise to just buy and sell all 10 of these stocks and be done with it?

Some might see wisdom in such a course, but James Early, our lead analyst at Motley Fool Income Investor, would recommend that you never invest in a company without a thorough evaluation of its management and competitive prospects. Otherwise, you might end up with a time bomb. GM, after all, is another member of this list. With the "b" word (bankruptcy) often mentioned when discussing the "titan," investors would be very wise to exercise due diligence when investing in even the bluest of blue-chip stocks.

Why not let the team at Motley Fool Income Investor assist you with your due diligence? As a former hedge-fund manager and investment research director, James Early knows his way around the balance sheet. Click here for a 30-day free trial.

John Reeves owns shares in Johnson & Johnson, which is an Income Investor recommendation. Merck is a former Income Investor pick. Pfizer is an Inside Value recommendation. John once had a dog named Reggie who was the best darn dog in the world. He is currently ranked 1,408 out of 19,208 in Motley Fool CAPS. The Fool has a disclosure policy.