On the surface, it seems obvious that chasing big dividends is smart trading. But in practice, a double-digit dividend stock may also be a red flag.
Because dividend yield is based on the dividend per share and current price per share, if the price plummets, the yield goes up. A big dividend could result from bigger problems in the fundamentals.
For the purpose of evaluating dividend yield, the reasons behind these changes are not important; what is important is the underlying cause of the decline. So if you chase big dividend yield as the only test of investing or trading a stock, be prepared for possible price decline and the potential for severe problems. Those big yields exist for a good reason. It is smart to know that reason before buying shares.
To overcome this problem, don't look only at the current dividend yield. Look at the 10-year record and also review what has been going on in other key fundamental indicators: revenue and earnings, P/E ratio, and debt ratio. These tell the bigger story. Also check current news about a company. If they have announced plans to file bankruptcy, the stock price may have fallen in recent days, and one result is a very large dividend. But it is not good news for stockholders, so be careful. Don't rely just on the yield.
In evaluating dividends, there are three tests worth performing. First is the yield, but rather than looking only at current yield, check the trend over many years. Has the yield been rising, flat or falling?
Second, review dividends per share paid over many years as well. Companies whose dividend has increased every year but the last 10 years or more are referred to as "dividend achievers," and this is a strong test of profitability and cash flow as well.
Third is the payout ratio, which is the percentage of earnings paid in dividends each year. It's not realistic to expect this to rise indefinitely, but a steady ratio is a promising sign. A falling ratio could signal trouble.
In conjunction with trends in dividend yield, dividend per share and payout ratio, also track the debt ratio for the same period. Is the debt rising, falling or remaining the same? If a company is increasing its dividends but financing payments with growing long-term debt, that is a troubling signal and a negative sign for stockholders. As a matter of cash management a profitability, a healthy dividend should be based on rising profits and careful management between earnings paid as dividends and earnings used for other reasons (buying and retiring stock, financing expansion, retiring debt, to name a few examples).
In addition to writing about technical analysis and options trading, Thomsett has written extensively about candlestick charting.You can discover the world of effective chart reading with Profitable Trading Strategies Using Candlestick Charting. This is a comprehensive and complete course on the nature of candlestick charting, offered exclusively by the Global Risk Management Community. By the conclusion of this course, you should be able to locate actionable candlestick signals, better understand what is likely to occur next, and combine candlesticks with other technical signals to forecast price movement. To find out more, go to Using Candlestick Charting
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