Why Chasing Dividend Yield Can Burn You

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Investing in dividend stocks is a smart way to build wealth, particularly with the Federal Reserve having further cut interest rates recently. Moreover, with the S&P 500's average yield hovering around 1.96% today, it is not surprising that many investors are turning to stocks with sky-high dividend yields. However, chasing dividend yield can be a dangerous game because high yields can sometimes signal that the company is in financial turmoil.

The pitfalls of lofty dividend yield
Everyone wants a great return on their investment dollars, and with companies such as real estate investment trust Annaly Capital Management and telecom giant Windstream Holdings boasting dividend yields of 9.68% and 10.70% respectively, these might seem like the best way to achieve that. However, a closer look reveals these stocks are ridden with risks. Annaly Capital, for example, paid out more in dividends over the last year than it earned -- a trend that is not sustainable over the long haul.

The same holds true for rural telecom company Windstream, which paid out $1 per share in dividends last year, yet only generated full-year earnings of $0.35 per share. Common sense tells us this is not something that can be maintained over the long-term. Another thing investors want to consider before jumping into a high-yield dividend is the payout ratio. Windstream currently has a payout ratio of 344%.

This is important because it tells investors how much of the company's net income is spent covering the stock's dividends. In Windstream's case, at 344% of the company's net income, the company is paying out more in dividends than it currently produces in net income. Moreover, management doesn't have any cash left over to sensibly invest in growing the business. Annaly Capital's payout is also dangerously high at around 192%. This will likely burn investors in these names when said companies are forced to cut their dividend.

From risky dividend yield to rewarding yield
With more than 400 companies within the S&P 500 paying shareholders cash dividends today, there are plenty of reliable dividend stocks available that don't run the risk of having their payout cut or their dividends slashed all together. Therefore, a smarter plan than chasing the highest yields is to find companies that continually put shareholders first, by growing their dividend for decades on end. A great place to start the vetting process is with Dividend Aristocrat stocks.

These stocks have consistently increased their dividends for 25 years or more. Procter & Gamble and PepsiCo are two Dividend Aristocrats that look particularly enticing today. Sure, they don't have the lofty yields of Annaly or Windstream, but they do generate more than enough cash flow to grow their payouts for many years to come, while also having enough money left over to reinvest in their respective businesses. P&G currently has a dividend yield of 3%, while Pepsi's yield is 2.80%, both of which are significantly better than the S&P 500's yield of 1.9%.

Procter & Gamble boasts a portfolio of 23 brands that each generate between $1 billion-$10 billion in annual sales for the consumer goods giant. This has enabled P&G to responsibly reward shareholders through dividend growth and share buybacks. The company has increased its dividend for the past 58 years running at a compounded rate of more than 9% a year. This, along with the stock's payout ratio of just 58%, tells investors Procter & Gamble should be able to continue paying a dividend for the next 50 years or more .

PepsiCo also delivers superior income to shareholders through low risk dividend growth. Pepsi has increased its payout for the past 42 straight years. The company recently bumped up its dividend by as much as 15% to $2.62 annually. And, similar to Procter & Gamble, Pepsi's payout ratio is just over 50% today. These stocks don't offer investors sky-high dividend yields, but they do afford shareholders something far more valuable: the promise of reliable dividend growth for many decades to come. Ultimately, this is a wiser path toward creating long-term wealth.

The safest and most rewarding dividend stocks money can buy today
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here.

The article Why Chasing Dividend Yield Can Burn You originally appeared on Fool.com.

Tamara Rutter owns PepsiCo. The Motley Fool recommends PepsiCo and Procter & Gamble. The Motley Fool owns shares of PepsiCo. 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. The Motley Fool has a disclosure policy.

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