Most income-oriented investors, heading into retirement or just preparing for this eventuality, focus on the given dividend yield of a particular investment before making an investment decision.
All things being equal (they never are, but you know), picking the company with the higher dividend yield may seem like the right thing to do. In this article, I’m going to highlight some concerns with such a strategy.
First, the rate at which companies grow their dividends over time matters a lot, particularly if one expects to live a very long time. Company A may pay a 5% dividend yield and Company B many pay a 6% yield.
However, if company A grows its dividend by 10% a year every year and company B only raises their divided by 5% each year in a short amount of time, Company A’s payout will surpass that of company B. Growth rates of dividends, and by extension cash flows, are therefore more important (in my opinion) than the dividend yield itself.
Second, dividend payouts for companies are optional and a given management team can choose to cut or eliminate a dividend at any time. If a dividend yield approaches a ridiculous level, the market is sending a signal it believes the dividend is unsustainable.
Higher-yielding companies are therefore at higher risk for a dividend cut.
Investors ought to also monitor closely the payout ratio (dividend divided by cash flow or earnings) to see how sustainable a yield is, particularly if one sees such a yield climbing rapidly.
Invest wisely, my friends.
