Dividend yields are “sexy” numbers in the world of dividend investing (which, by in large, is an unexciting, but lucrative, subset of equity investing). Dividend investors tend to gravitate towards it because it is an easy to understand number of a rate of return at any particular period of time. But is there such a thing as too great of a dividend yield?
Let’s start at the beginning. Dividend yield is percentage determined the formula = annual dividend per share/share price. It stands to reason then that dividend yields increase in one of two manners:
- The dividend increase is greater than the share price increase; or
- The dividend remains constant but the share price is falling.
It is harder to affect the first than the second and the second tends to occur during down markets when share prices fall rapidly while the dividend paid remains the same. As we are all seeing when publicly traded companies hit hard times, and their share prices are re-set accordingly, dividend yields tend to shoot up followed, in some instances, by the company slashing the dividend.
This may create the impression that unusually high dividend yields cannot sustain themselves for long in down markets and the dividends slashed eventually as a cost-saving measure. But is a high dividend yield in down times necessarily a harbinger of a dividend decease?
It depends (as usual). The focus should not be on the stock price per se but digging into the statement of cash flows. At the end of the day, a company can only pay a dividend if it has the cash flow to support it. In any company’s financial statements (interim or audited), there is a line called “cash flow from operating activities.” This is pretty self-explanatory.
Now do the following if it hasn’t been done for you (I recommend MSN Money which does this substantially for you; here is an example they run on Pfizer):
Net income + depreciation/depletion - change in working capital - capital expenditure.
The sum of this is free cash flow. Free cash flow is the cash remaining after a company has spent money to maintain or buy its assets (think maintenance costs on old machines; purchasing new computer networks etc.). Its not just cash from operations you have to focus on but cash remaining after paying out its fixed over-head to keep the company running.
Now go to “net cash” which is at the bottom of the statement of cash flow and get that number.
