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 land-line telecom player Frontier Communications (NYS: FTR) , for instance. Over the past 12 months, the company has paid out 461% of its income in dividends and over the past three years has paid out an average of 303% of earnings (Frontier's free cash flow is well above its net income).
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, the dividend yield for glass kingpin Corning (NYS: GLW) of 1.6% may look puny next to Frontier's heftier 12.2% dividend, but over the past 12 months, Corning has paid out a mere 9% of its income in the form of dividends. But what would happen if Corning was more like Frontier and paid out, say, 90% of its income? That 1.6% yield suddenly jumps to a huge 15%.
Could Corning actually pull that off? The company isn't blessed with the same cash flow dynamics as Frontier, so we may not want to assume it can really pay out 90% of its earnings. However, if it paid out 90% of its free cash flow, it could pay a dividend more than 5 times what it pays today. And while Corning's business is relatively cyclical, its conservative cash management has left it with $6.4 billion in cash and just $2.3 billion in debt (Frontier has $233 million in cash and $8.2 billion in debt). So while I wouldn't hold my breath for a massive Corning dividend, it's very clear that the company has the capacity to pay out much more than it does.
Now, it may seem like on odd comparison to stack Corning's theoretical 15% payout against Frontier's actual 12.2% 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 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.
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At the time thisarticle was published Motley Fool newsletter serviceshave recommended buying shares of Corning. 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 on Facebook. The Fool'sdisclosure policyprefers dividends over a sharp stick in the eye.
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