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 as dividends. Take telecom dividend champ CenturyLink (NYS: CTL) , for instance. Over the past 12 months, the company has paid out 143% of its income in dividends and over the past three 12-month periods, its average payout ratio has been 105%.
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.
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, ExxonMobil's (NYS: XOM) 2.6% payout may look meager next to CenturyLink's whopping 8.8% dividend, but over the past 12 months ExxonMobil has paid out a mere 24% of its income in the form of dividends. What would happen if ExxonMobil was more like CenturyLink and paid out 90% of its income? That small 2.6% yield would suddenly jump to 9.5%.
Exxon does, of course, face challenges. The company sells a commodity product and has to tangle with global giants like Chevron (NYS: CVX) , ConocoPhillips (NYS: COP) , and Petrobras (NYS: PBR) . A sluggish global economy could hurt demand for oil -- and therefore oil prices -- while finding new oil fields means working in tougher-to-negotiate areas like deep water. But I guarantee that investors would be tripping over themselves to buy Exxon's stock if it suddenly had a 9.5% payout.
It may seem like on odd comparison to stack Exxon's theoretical 9.5% payout against CenturyLink's actual 8.8% 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 instead simply choose to reinvest for future growth, buy back shares, or hang onto extra cash. That doesn't mean you should consistently pass up big dividends for smaller ones, but it does mean that 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.
At the time thisarticle was published The Motley Fool owns shares of Petroleo Brasileiro. Motley Fool newsletter services have recommended buying shares of Chevron and Petroleo Brasileiro. 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 Chevron, 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.
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