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 most, if not all, of their income through those dividends. Take telecom kingpin Verizon (NYS: VZ) , for instance. Over the past 12 months, the company has paid out 86% of its income in dividends and over the past three 12-month periods -- if we adjust last year for a big restructuring charge -- its average payout ratio has been 91%.
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, GE's (NYS: GE) 4% payout may not look very generous next to Verizon's heftier 5.7% dividend, but over the past 12 months GE has paid out a mere 41% of its income in the form of dividends. But what would happen if GE was more like Verizon and paid out 90% of its income? That 4% yield suddenly jumps to 7.4%.
Investors don't feel the same way today about GE that they once did. The highly successful industrial and health-care businesses of the company, which line up with well-liked companies such as 3M (NYS: MMM) and Emerson Electric (NYS: EMR) , were overshadowed by problems with its finance business. But management has been addressing the finance segment issues while refocusing the business as a whole by making moves like the sale of NBC into a joint venture with Comcast (NAS: CMCSA) . All that aside, though, I guarantee that investors would be tripping over themselves to buy GE's stock if it suddenly had a 7.4% payout.
Now it may seem like on odd comparison to stack GE's theoretical 7.4% payout against Verizon's actual 5.7% 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 either reinvest some of their earnings for future growth, buy back shares, or hang onto some extra cash. That doesn't mean that 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 Motley Fool newsletter services have recommended buying shares of 3M and Emerson Electric. 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 3M, 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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