InvestorQ : Is it true that all high dividend yield stocks end up being value traps? How do I select good dividend yield stocks that do not end up being value traps?
Aditi Sharma made post

Is it true that all high dividend yield stocks end up being value traps? How do I select good dividend yield stocks that do not end up being value traps?

Aashna Tripathi answered.
2 years ago

Have you ever wondered why dividend yield stocks are not normally preferred by savvy individual and institutional value investors? This is not a coincidence but it actually has reasons.

· Firstly, who wants low growth stocks? Most dividend yield stocks tend to be low growth stocks and the stock market is always willing to pay a higher P/E for growth stocks. Dividend yield stocks rarely see positive re-rating of their P/E ratio. That really works as a value ceiling for these dividend yield stocks.

· Apart from growth, there is a problem of perception too. Past experience has shown that high dividend yield stocks have limited investment and growth opportunities in the core business. Most equity investors prefer a stake in the business. High dividends hint at limited expansion and diversification opportunities.

· If you quickly evaluate the nature of stocks that are giving high dividend yields, you will find them in sectors like utilities and commodities. These are either vulnerable to global price cycles or to government regulation. In the US, such companies are preferred only by retirees who want to rely on regular income to fund their expenses.

· Dividends are partial liquidation of the business. Companies have two choices in front of them. They can pay out more of their profits as dividends or they can plough back their profits into reserves. Normally, companies with higher growth potential and higher ROE prefer to plough back profits. That works against these dividend yield companies.

· Lastly, don’t forget the tax part. There are 3 levels of taxation on dividends. Firstly, dividends are a post-tax appropriation and hence there is no tax shield (unlike interest on debt). Secondly, when the company declares dividends there is a dividend distribution tax (DDT) of 15% which reduces the net dividend on hand. Lastly, the 10% tax on dividends above Rs.1 million also reduces its attractiveness.

Investors do not prefer high dividend stocks as they tend to be low growth stocks in saturated industries. That is not the recipe for creating wealth in equities. Also, past dividends are not a guarantee of future dividends. If you also look at some of the best market value creators in the last 20 years, they have rarely been high dividend yield companies.

Let us now look at whether it is possible to make the dividend approach work for you?

Dividend yield is a supplementary valuation measure as distinct from P/E ration and P/BV ratio. Here are 3 instances where the dividend yield can be a useful metrics.

Dividend yield is a good investment idea if you are seeking regular income in the form of dividends from stocks. When the dividend yields are more than the yields on debt then there is an additional case for investing in dividend yield stocks.

Dividend yields act as a base below which the price of a stock does not fall. More often than not, the dividend yield of around 5-6% acts as a price support for the stock as below that price the dividend yield becomes attractive and invites buyers.

The moral of the story is that investors tend to look at high dividend yield stocks as non-growth stories and no value investor wants to be caught in a stock that does not grow. The argument is that dividends are being distributed purely because they do not have any investment or expansion opportunities. That depresses the valuation of the stock. However, dividend yield is useful as a method of gauging the overall valuation of the market and as an adjunct to P/E ratio and the P/BV ratio.