Dividends are a hot topic for many investors right now. The turmoil of the financial meltdown is still fresh and the tangibility of a quarterly cash payout hits the spot like a cool glass of lemonade on a midsummer day in the desert.
Not surprisingly, investors have been drawn to companies that feature massive dividend yields. And why not? If you're going to go for dividends, why not go big.
But the catch is that many -- if not most -- of the companies with huge dividend yields get those yields by paying out nearly all, if not all, of their income through those dividends. Take pharmaceutical giant Pfizer
By focusing on the dividend yield alone, investors can end up overlooking the bigger picture. A dividend-paying company with a high payout ratio may have a tougher time maintaining its payout if it hits a speed bump. It may also have little capital left behind to reinvest in the business and might be forced to load up on debt or sell new shares if it wants to grow. Or it may simply be admitting that its growthy days are in the past.
A laser-focus on dividend yields also means that investors may not be comparing potential investments on an apples-to-apples basis.
At first glance, the dividend yield for fellow pharma company Teva Pharmaceutical
Could Teva actually pull that off? A company's cash flow statement usually tells that story, and so we can get a pretty good idea from looking at Teva's. In short, the answer is "yes," Teva could handle that kind of payout, or at least something very close to it. However, the company has spent an awful lot in recent years on growth-boosting acquisitions, and that would become a lot more difficult if it was making a huge dividend payment to shareholders. Not that the company couldn't play some "have my cake and eat it, too" -- Pfizer, along with other pharma giants including Merck
With that in mind, it may seem like on odd comparison to stack Teva's theoretical 6.7% payout against Pfizer's actual 4.2% yield. But this is meant as a thought exercise and a reminder that a dividend yield is only part of the story. Many really great companies have the earnings power to pay truly massive dividends but simply choose to reinvest some of their earnings for future growth (be it organic or through acquisitions), buy back shares, or hang onto some extra cash. That doesn't mean you should consistently pass up big dividends for smaller ones, but it does mean you may miss out on some really great companies if the one and only stop in your research is to ogle a stock's yield.
Want tag either of these companies to keep an eye on them? Add them to your Foolish watchlist by clicking the "+" next to the ticker or start a brand new watchlist for free.
The Motley Fool owns shares of Teva Pharmaceutical Industries. Motley Fool newsletter services have recommended buying shares of Teva Pharmaceutical Industries and Pfizer. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of Teva and Eli Lilly, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.