When evaluating high-yield dividend stocks, investors are ultimately trying to differentiate between undervalued companies and yield traps. The former can represent very rewarding buying opportunities, while the latter can cause significant loss of capital in collapsing companies.
This distinction often appears obvious in hindsight, but is extremely difficult in real time. Though each situation is unique — each company and environment presents new wrinkles — there are some standardized metrics that can be examined in an effort to determine the outlook for high-yield stocks.
Revenue Growth
When considering a high-yield dividend stock, perhaps the most useful metric to analyze is one of the first presented in the financial statements.
To make an extreme simplification, high yields often appear for one of two reasons: a company is in decline, or it is being temporarily undervalued by the market. The trajectory of top-line revenue can often help investors determine which is applicable to a particular name. Yield traps entering a slide toward bankruptcy tend to exhibit negative revenue growth, while undervalued companies continue to deliver positive revenue growth.
The companies shown above have very different revenue growth stories. Philip Morris and Mattel are experiencing major declines, while the other companies are at least squeezing out modest top line improvements.
A company must ultimately do a lot more than grow revenue to deliver value to shareholders. But positive revenue growth is certainly a positive indicator in evaluating a high-yield stock.
Profit Margins
Both the absolute profit margins and recent trends can provide insights into the challenges or opportunities that exist at a company.
Companies that have relatively high EBITDA margins may have the luxury of being able to withstand downturns. On the other hand, companies with single-digit margins (e.g. Wal-Mart) have very little room for error when they encounter challenges.
The following table shows the EBITDA margins for the same companies listed above, all of which have relatively high margins:
Changes in profit margins can be instructive as well. When a stock price falls but profitability remains, a buying opportunity may exist. But the sudden collapse of profit margins can indicate that a dividend cut or elimination is in the cards.
Payout Ratio
The payout ratio can be very instructive about the safety of a dividend — and therefore the attractiveness of a high-yield stock. Simply put, companies with high payout ratios are likely to be paying an unsustainable dividend.
Consider the dividend strategy implemented by Cincinnati Financial (CINF), a major insurance provider, leading up to and during the financial crisis. The company paid out a relatively small portion of its earnings in the form of dividends between 2005 and 2007, electing to build a cushion with some of its profits:
As the company’s earnings declined significantly in 2008 and 2009, the payout ratio skyrocketed from just 25 percent in 2006 to nearly 60 percent. Even with that jump, however, the ratio remained well below 100 percent.
Even at the equity market lows in early 2009, CINF had plenty of breathing room. When the dividend yield approached 8 percent, many savvy (or lucky) investors bought up shares. The company has continued to increase its dividend and maintain a moderate payout ratios, and shares have surged since 2009.
Avon Products (AVP) illustrates the warning sign that a payout ratio can flash. Between 2008 and 2011, the payout ratio climbed from less than 40 percent to nearly 80 percent. When earnings turned negative in 2012, the company had no choice but to slash its payout:
Cash and Debt
At the risk of sounding obvious, the amount of cash and debt on hand are important when evaluating a high-yield dividend stock. At the end of Avon’s disastrous 2012, the company had only about $1.2 billion in cash and $3.2 billion in debt — including nearly $600 million maturing within one year.
It should have been obvious at the time that the company was at best facing a major restructuring and at worst headed into bankruptcy.
Stock Price Volatility
This metric is unique from the others on this list in that it isn’t reported in the financial statements, but rather determined by the activity of buyers and sellers of the stock. The market can, of course, be wrong about the outlook individual stocks — but it’s generally a pretty good guide.
A stock with a high dividend yield and high beta is likely to be a company encountering serious challenges. In these uncertain environments, stocks often experience big gains and losses. The best and worst single trading days in the history of many companies occurred in the second half of 2008 — during one of the worst environments for stocks.
The combination of a high yield and a relatively low beta may indicate a more stable firm with less upside potential and downside risk. These stocks may be facing low growth expectations, but generally aren’t in a fight for survival.
As shown above, FTR and VZ have betas well below 1.0, indicating that they are less volatile than the general market. Mattel, on the other hand, has been rather volatile.
Buybacks and Insider Trades
The level of stock buybacks by the company and activity of insiders may also be useful pieces of information. Though buybacks are becoming more common, they should theoretically increase when management believes that a company is undervalued (and, perhaps more importantly, feels confident enough to spend cash to purchase shares).
These metrics certainly aren’t foolproof. Few of the strong companies were bold enough to make buybacks during the 2008 recession. CINF, which was highlighted above as an excellent buy at the time, basically discontinued its buyback program to conserve cash.
Puzzle Pieces
Evaluating high-yield dividend stocks is a complex task that rarely reveals an easy answer. In many cases, the metrics highlighted above will give conflicting indications about the health of a company. But investors who conduct a thoughtful analysis will be more likely to steer clear of the yield traps out there and focus in on the attractive buying opportunities.
This article, How to Evaluate High-Yield Dividend Stocks, first appeared on Dividend Reference.