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 pipeline giant Enterprise Products Partners (NYS: EPD) , for instance. Over the past 12 months, the company has paid out 107% of its income in dividends, and before being unprofitable a year ago, it paid out 103% of its earnings two years ago.
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, Medtronic's (NYS: MDT) 2.8% payout may not look very generous next to Enterprise's heftier 5.9% dividend, but over the past 12 months Medtronic has paid out a mere 32% of its income in the form of dividends. But what would happen if Medtronic was more like Enterprise and paid out 90% of its income? That 2.8% yield suddenly jumps to a fatter 7.5%.
As they say, sometimes you have to spend money to make money, and if Medtronic wants to keep pace with tough competitors like Boston Scientific (NYS: BSX) , Johnson & Johnson (NYS: JNJ) , and St. Jude Medical (NYS: STJ) , it won't want to completely drain its financial resources. However, as it is, most years the company spends as much or more on share buybacks -- which I'm not a big fan of -- as it does on dividends. Shifting that buyback spending and doubling its dividend wouldn't get it to 7.5%, but the 5.6% yield that it would produce would almost certainly bring income investors swarming like bees to honey.
Now, it may seem like an odd comparison to stack Medtronic's theoretical 7.5% (or 5.6%) payout against Enterprise's actual 5.9% 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 Medtronic, St. Jude Medical, and Johnson & Johnson.Motley Fool newsletter serviceshave recommended buying shares of Enterprise Products Partners and Johnson & Johnson and creating a diagonal call position in Johnson & Johnson. 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 Koppenhefferowns shares of Medtronic and Johnson & Johnson but has no financial interest in any of the other 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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