A stock that can grow its dividend payments over time consistently provides compounding like no other opportunity. Naturally, investors try to maximize this compounding by searching for high dividend stocks. It’s a great idea but it comes with some hidden dangers.

Let’s be clear. It doesn’t take much reading of our site to figure out how strongly I feel about dividends. I push for dividends and only buy stocks that pay dividends. To me, it’s not really investing unless you are getting paid a steady stream of income over time.

Also, many good dividend growth picks of the past had a double compounding effect for the investors. Companies like KO, PG, WMT, MO and others, were able to not only increase their share price by 10s of percent per year but also sustain double digit dividend payment growth.

Some of the best investing stories come from ordinary people who bought a couple good dividend stocks and held them for the long term, letting the company do all of the work for them. I’m talking about 10s of thousands of dollars turning into 100 of thousands or millions.

Let me tell you one quick example.

The Dividend Stock Widow

This is true story about investing told by hedge fund manager Joe Ponzio.

He met a woman named Rose who tells of the time her husband Fred died in 1966. Now, Fred was a successful businessman and left the family with good life insurance. However, they still had one child left in an expensive med school problem.

And Rose was left without an income or any means to make an income.

It just wasn’t possible for a mid 40s woman with no experience to get a job in that time period. Luckily, she knew about the income generating stock market.

Rose didn’t know too much about investing. So she bought the big names– like Coca Cola, Johnson & Johnson, and Pepsi. She didn’t bother with trying to time the market… after all, she needed the income from these dividends to pay for all her expenses. So she couldn’t sell them.

Instead of “going to work”, Rose would go to the library and read annual reports. She had her brother help her calculate the intrinsic value of these companies so she’d know at what price to buy them.

Rose started in 1966 with $10,000. By 2001, her portfolio was worth $200,000+. By 2008… she had a portfolio of over $2.5 million. 

Business Results, Dividends and Investors

This kind of success is typical for investments in a very successful company. If it’s been done before it can be done again. And since executives at these companies obtained great personal financial success from these endeavors, executives at other companies are incentivized to model what they did– which includes paying a steady and growing dividend out to shareholders for a very long time.

Well, if it was done in the past, won’t all investors look for these situations?

You’d be surprised by how many investors don’t take the time to learn from the past. They believe that they live in a unique time, powered by computers and the internet.

It’s true in a sense, but the market and its lessons stay steady over time. Like the basic principles and virtues that have stood the test of time, the stock market has and always will deal with unique and new circumstances with one common denominator… the inclusion of people.

People, as investors, are irrational and emotional yet believe themselves to be the opposite. Like with their driving skills, people all think they are better than the average.

As it goes… the crowd frequently ignores dividend growth stocks, high dividend stocks, dividends with very long track records, all because they tend to chase short term price appreciation and the rush of being involved with the most popular stocks.

It’s like gambling. People willingly blow through large amounts of money for the thrill, and you’ll see many flock to the craps table with a loud and excited group surrounding it. I do the same, whether in Vegas or in London.

Institutional investors (I’m talking about fund managers with large amounts of capital to manage) fall into the same trap. They fill their portfolio with the most popular and thrilling stocks because these attract more investors seeking someone to manage their capital.

Oftentimes this involves stocks that don’t bother to pay a dividend. The executives at these kind of companies don’t have to pay a dividend to attract shareholders because they already have willing buyers.

While the general public calls these type of non-dividend payers  “the future”, “innovative” and “world changing”, I like to attach a different type of label: “bubble stock”.

Again, this is a topic that isn’t talked about enough. There’s always a large group of bubble stocks that lead stocks to higher highs, yet those same stocks also lead stocks down to treacherous crashes. Bubbles pop, and it’s nothing new. Yet like dying or getting in a car accident, people think it won’t happen to them. What’s funny is that the survival rate on this planet is 0%… eventually.

Okay, so why am I telling you all of this?

The whole point is to both caution you and excite you.

Because the general public tends to greedily bid up stocks to bubble proportions, many stocks fall under the radar and make for great undiscovered opportunities. But at the same time, many high dividend stocks can also catch themselves falling into bubble territory unannounced. In this post I will teach you how to avoid these traps.

Let’s go back to the basics real quick.

Why am I so adamant about dividends?

Take an example where a stock is paying a 4% dividend. Sure it’s nice to invest money and get an income like that, but that’s not where I get excited.

Instead let’s have this hypothetical stock growing its dividend by 20% a year, which isn’t that hard to find. That means that after one year, you’re getting a 4.8% yield. After 5 years, that yield has increased to 9.9%. As long as you didn’t sell the stock, you’d be getting a 9.9% income stream from your original purchase. And ideally it’d still being increasing each year.

That’s compounding interest at work. Because companies on Wall Street are pressured to constantly grow earnings (profit) by 10s of % every year, achieving these results involves naturally compounding capital– leading to compounding dividend payments.

And 5 years of holding a stock is a relatively short term. You can do the math for much longer time periods and see a much higher yield on cost, a higher income proportional to the amount invested.

But the goodness doesn’t stop there. A second component of this leads to even higher profits for the shareholder.

I’m talking about dividend reinvestment.

Let’s take that same hypothetical of the dividend paying 4%. Let’s say you reinvested each dividend you received to buy more stock in the same company. So after a year (holding the stock price constant for simplicity), you’d have 1.04 shares and a 4.99% yield instead of 4.8%. After 5 years, your yield on cost would be 13%.

Here’s how I did that:

Multiplying the yield by 1.2 each year (20% growth):

• Start: 4%
• Year 1: 4.08%
• Year 2: 5.76%
• Year 3: 6.91%
• Year 4: 8.29%
• Year 5: 9.95%

Now here’s with dividend reinvestment:

• Start: 4%
• Year 1: 4.9%, 1.04 shares
• Year 2: 6.2%, 1.08 shares
• Year 3: 7.9%, 1.22 shares
• Year 4: 10%,  1.32 shares
• Year 5: 13%,  1.45 shares

See. You receive more dividends the more shares you accumulate, even for partial shares. You’ve almost gained 50% just from dividends alone, because you now have 1.45 shares instead of 1.

It’s actually a double compounding interest effect, and the growth exponentially increases on itself. The accelerated compounding compounds on itself. That’s the power of consistent dividend growth, and we’re not even touching the great possibility of the stock price increasing making those additional shares even more valuable.

Now not every stock follows this perfect kind of scenario. Obviously the real world results in varying degrees of success– in growth, business profits and market conditions.

And actually stocks that are bought at too high a price can crash down substantially, making those additional shares worth a fraction of what you paid. This is what happens to dividend stocks that turn into bubble stocks, and the poor performance of these investments can negate much of the gains of other positions in your portfolio.

So let’s learn how to identify and avoid the dangerous high dividend stocks in the market. It just takes a little digging and some basic math, and you’ll be way ahead of the game.

Payout Ratio

You can find this data point in most financial websites for most any stock. It simply looks at what percentage of earnings a company pays out in a dividend.

To understand this ratio we must understand what the nuts and bolts are that lead to a company being able to pay a dividend. A public corporation first turns a profit. This is step 1.

Now that the company has excess cash, it must decide how much of it to reinvest in the business. This can mean buying assets which will produce more cash in the future, paying down debt to reduce risk and negative cash flow from interest payments, or investing it in the market to enlarge the cash position, or even keeping the cash for emergencies.

The corporation can also decide to return that extra cash to shareholders. This benefits the executives of the company because it attracts other investors to buy the stock, pushing the stock price higher. The corporation returns cash to shareholders by buying back stock to also push the price up and enrich shareholders, or by paying a dividend.

Like most things in business, life, and the markets, there should be a good balance to the dividend payment.

A company paying all of its earnings in dividends isn’t a good sign, because it means they are either risking the long term health of the company for a short term high yield. Or it can’t make that cash earn a good ROI to increase profits in its own business… another bad sign.

At the other end of the stick, a company that pays too little of its earnings as a dividend clearly doesn’t care much about their shareholders. What does that say about management? Do you want to be an owner of a corporation where the leaders don’t care about your best interests? This also adversely affects your personal results, limiting the compounding I talked about above.

To discover how much of earnings a company is either reinvesting or paying back, simply use the payout ratio.

The payout ratio is a number from 0 – 1. 0 means the company doesn’t pay any of its earnings back as a dividend, a 1 means all of its earnings back as a dividend. A payout ratio above 1 means they are paying more of their earnings to pay a dividend, which is a huge red flag.

If you want to calculate the payout ratio for yourself, simply take the dividend payment and divide it by the earnings per share.

A good payout ratio depends on the industry and individual company. The point of using this ratio isn’t to find good opportunities but rather keep you away from bad ones. Obvious instances of interest include any payout ratio over 1, and an increasing concern the closer a ratio is from 1 instead of 0.

Price to Earnings Ratio (P/E)

In a nutshell, this ratio will tell you how expensive the stock is that you are buying. Because the market is complex and has many variables, it's not the be-all/end-all determining factor. But it’s a good first start and an easy one that the crowd misses.

Basically the ratio is calculated by taking a company’s price in the market– market capitalization– and dividing it by its earnings– the net earnings of the latest year from its annual report.

Side note: Most financial websites calculate this ratio based on latest quarterly earnings result. I don’t like to do this because many companies see higher positive results in particular quarters… think retailers during Christmas season. For that reason and others I use the latest annual report net earnings.

Knowing how this ratio is calculate tells us its usefulness. You can see that it is basically telling us how high or low of a price we are paying for a certain number of earnings.

The reason this is useful is because it allows us to compare large companies with small companies. Obviously a smaller company won’t be able to earn as many profits as a large one, but if we aren’t paying as big a price for those earnings it could be the better deal.

As an example…

Let’s say you had 2 options. Buy a lemonade stand for $100 that’s making $25 a day or buy an arcade for $20,000 that's making $300 a day.

Maybe at first the arcade seems like a better buy, especially if you have plenty of capital to buy it. After all, surely you’d grow your wealth faster with a $300 daily income rather than a $25 one.

But take the P/E of these 2 examples.

• Lemonade stand:      100/25 = 4
• Arcade place: 20,000/300 = 66

The P/E of the lemonade stand is much lower, which means it’s cheaper. Why? Because you can buy 200 lemonade stands at $100 and be making a $5000 daily income instead of buying one arcade at the same price for a $300 income.

The hard part would be finding 200 lemonade stands at such a great price, but luckily the stock market lets us buy as many shares as you want– unless you’re a billionaire and are bigger than the company itself.

It seems like such a no-brainer when we look at it this way, right?

And the stock market is actually the same way. Buying shares is no different than owning little pieces of a large company, that’s literally the definition. So in essence, investors are actually business owners and not just traders exchanging pieces of papers.

That kind of mindset is the one you need for success, and is again lost by the majority of the crowd.

A good P/E ratio is a lower one. Like the payout ratio, it can be very useful in avoiding major red flags and bubble stock situations. However it’s different in that the lower it goes the more money it can make you, and the better of an opportunity it can signal.

As a general rule of thumb, a P/E over 50 is very expensive and anything over 25 can mean it’s starting to get expensive.

But a company that is expensive is sometimes justified if it’s compounding its earnings at a superior rate. Back to the lemonade/ arcade example, if the arcade is growing its earnings so much faster that it will surpass the lemonade income in the long term AND it’s not spending a lot of capital or going into debt to do so, then it could be worth it.

But, this tends to happen more for stocks below the 50 mark and even more often much lower than that. I’d never invest in a stock with a P/E close to 50, yet the 25 isn’t a hard and fast rule. I could be in a stock with a P/E of 26 or 28 depending on the situation.

Benjamin Graham, who was Warren Buffett’s mentor and the source of many super-investors’ successes, recommends a P/E below 15. Heed that recommendation with respect.

P/E ratio isn’t the panacea of determining a company’s value, whether it’s cheap or expensive, but it is a good start. If you understand and intrigued, I’d recommend continuing with the P/S, P/B, and other important metrics.

Debt to Equity Ratio

The last danger I’ll discuss with regards to high dividend stocks is the debt to equity ratio. This one isn’t obvious and I’d say is the most overlooked by the general public.

Yet it’s the most potentially dangerous.

While not directly related to the dividend, it signals an aggressive company that is fueling results with debt. This isn’t sustainable in the long term. When looking at dividend stocks, please don’t get seduced by high dividend stocks with extremely attractive yields or dividend growth rates.

The long term health of a business is far more important because it will eventually lead to great dividend results. Business results drive the dividend, not the other way around.

My last example involves Enron.

They were highly touted by the investing industry, and for good reason on the surface. Their earnings numbers and growth rates were fantastic. The dividend payouts and growth rates were also fantastic. It was knighted as #5 on the Fortune 500 list at its peak.

But not many people bothered to look at its balance sheet to see if it was fueling good results through debt leverage. Sure enough, they had a debt to equity around 29, which is about 29x more debt than the average company and 2.9x more debt than the average financial company (banks, insurance, etc.)

The average debt to equity across the market is 1. That value means for every $1 of debt a company holds, they also hold $1 of equity to back it up. Equity is the number of assets (what it owns) in excess of its liabilities (what it owes). A debt to equity of 2 means $2 of debt for $1 of equity, etc.

This metric being a ratio allows you to compare a company regardless of its size just like the other metrics in this post. A debt to equity below 1 is extremely preferred, the lower the better.

Like the payout ratio, a low debt to equity by itself doesn’t necessarily indicate a great buying opportunity. But it is a steady measurement of a company’s health.

A sound balance sheet with a small debt to equity ratio is extremely important especially when stocks are nearing highs. It’s building your investments on a foundation of solid ground rather than sand, and is especially important when a hurricane passes by… such as a bear market.

To calculate debt to equity it’s this:

          Debt to Equity = Total Liabilities / Shareholder’s Equity

Many finance websites with tickers displayed will show you this ratio, and some let you go deeper and show you liabilities and assets numbers themselves. I recommend calculating this one yourself, and here’s why.

Many websites calculate the debt to equity ratio as Long Term Debt / Shareholder’s Equity. I don’t agree with this. I want to know the whole extent of what a company owes and is responsible for, not just the effect of interest payments and such.

The most reliable way to calculate this for yourself is to pull up the stock’s annual reports that are publicly available. It’s somewhat confusing so I made an easy guide you can use to learn this skill.

Now, think again of the Enron example. I tend to stay away from financial industry stocks specifically because they are so leveraged on average. I understand that’s how they generate profits, but I think it’s too difficult and risky to measure to what extent it is prudent or not. If the big bailouts of 2008 taught me anything, it only reinforced this idea.

So I measure debt to equity on any company without giving special exclusions no matter the individual company or industry it’s in. A company either has a lot of liabilities to pay or it doesn’t.

In Conclusion

There’s many other numbers that signal whether a high dividend yield stock is a good buy or not. For sure starting with stocks at a high yield is a great place to be in. There’s plenty of websites online that update lists like this frequently.

But I caution you to also go past the surface and do a little digging. Learn how to read annual reports. It doesn’t take much time at all, but can make a big difference in the results you eventually get.

Go out and get that double compounding interest. But do it in a prudent way. Diversify. Use a long term approach, buy conservatively leveraged stocks, with strong earnings, and at a good price.