One mistake that many beginning investors (and some seasoned investors, as well) make is to put too much stock in one or a few measures as they evaluate companies as possible investments. For example, if you're new to investing and you learn what a P/E ratio is, you may excitedly proceed to look for stocks with low P/Es, thinking that you're finding bargains. But once you learn more about investing and about P/Es, you'll realize that things are not as simple as they may seem. The P/E is not a perfect indicator of value.
These days, some investors may be tempted by certain companies because of another seemingly attractive measure -- high dividend yields. Look at General Motors (NYSE:GM), for example, recently trading with a yield near 7%. It's hard not to be enticed by that. Invest $5,000 in GM stock and you'll seemingly set yourself up to receive a whopping $350 in dividends each year. Woo hoo!
But hold on, Sparky. Yes, dividends are terrific for investors, offering a second (and often more reliable) way to profit from stocks, in addition to price appreciation. We've written many times about the power of dividends and how they can make you rich:
- How to Achieve 20% Yields
- Beat the Market With Less Risk
- Dripping With Dividends
- Extra Dividends, Extra Growth
Dividends aren't foolproof, though. Ones that are especially high demand extra scrutiny -- because of math. A dividend yield simply represents a ratio of annual dividend divided by current stock price. Think of it as a fraction and remember that dividend amounts generally don't change too often -- perhaps once every year or few years. The stock price, though, does change, almost daily. So as the price rises, the yield falls. And vice versa. A high dividend yield, therefore, sometimes reflects not a terrific opportunity, but a company in trouble, or at least mired in uncertainty.
That's exactly the case at GM. As Stephen D. Simpson explained in this article, GM is facing many problems right now, such as falling SUV sales and steep retirement and health-care costs. The stock plunged roughly 40% over the past year, most recently on an earnings warning. When companies face deep problems, their dividends become less-sure things. Companies hate to do it, but sometimes they cut their dividends or eliminate them entirely. In the past, Ford Motor Company (NYSE:F) reduced its dividend, while auto part supplier Visteon (NYSE:VC) recently eliminated its dividend entirely.
Another company with a significant dividend yield due to a fallen stock price is Maytag (NYSE:MYG). The stock has fallen more than 50% over the past year. Merck (NYSE:MRK) is another fallen star. (Read Foolish thoughts on Merck and Maytag.)
So what should you do, as you scour the business world looking for promising investments? Well, for starters, keep learning and never stop. Bookmark this page, perhaps, as it holds links to many educational articles. Consider trying one of our well-received How-To Guides.
You might also consider grabbing a free trial of some of our newsletters. That way, you can see which stocks our analysts have recommended and how they're doing. (Our newsletters have impressive track records -- check them out.) Our Income Investor newsletter focuses on dividend payers, while our Inside Value newsletter seeks out undervalued opportunities.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
