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 real estate investment trust (REIT) favorite Chimera Investment (NYS: CIM) for instance. Over the past 12 months, the company has paid out 108% of its income in dividends, and over the past two 12-month periods (it wasn't profitable before that) its average payout ratio has been 88%.
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, Hewlett Packard's (NYS: HPQ) 2.1% payout may not look very generous next to Chimera's heftier 18.2% dividend, but over the past 12 months HP has paid out a mere 8% of its income in the form of dividends. But what would happen if HP was more like Chimera and paid out 90% of its income? That 2.1% yield suddenly jumps to a huge 16.7%.
We certainly don't want to overlook the fact that HP is a company under fire. Recently, it announced that it's reshuffling its business, looking to make an IBM-esque (NYS: IBM) shift to software and move away from scrapping with tough PC-manufacturers like Dell (NAS: DELL) and Lenovo. Meanwhile, it seems to have figured out that Apple (NAS: AAPL) and Google (NAS: GOOG) are eating its lunch in the mobile-operating-system business. It also decided to make what looks like a pretty dumb acquisition. Investors are fed up and have pretty much given up on the company and its management. However, I guarantee that investors would be tripping over themselves to buy HP's stock if it suddenly had a 16.7% payout.
Now it may seem like on odd comparison to stack HP's theoretical 16.7% payout against Chimera's actual 18.2% 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 either reinvest some of their earnings for future growth, buy back shares, or hang on to 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 The Motley Fool owns shares of IBM, Google, Apple, and Chimera Investment.Motley Fool newsletter serviceshave recommended buying shares of Apple, Dell, and Google and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.Fool contributorMatt Koppenhefferhas no financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting hisCAPS portfolio, or you can follow Matt on Twitter, where he goes by@KoppTheFool, or onFacebook. The Fool'sdisclosure policyprefers dividends over a sharp stick in the eye.
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