High Dividend Yield Stocks May Not Be The Right Choice: Here's Why

High dividend paying until last fiscal year were attractive because these were tax free in the hands of investors. Now, here we are discussing as to why dividend yield is a far more important factor in comparison to dividend.

Now dividend yield which is the return that an investor gets on the market price of the stock can be given in the form of the following equation which can be Annual dividend in rupees/ Current market price of the stock

Dividend yield can also be given as Annual dividend/ Net profit * Net profit/Current market price

This equation suggests that dividend yield is the product of the dividend payout ratio and the earnings yield of the stock. And earnings yield is nothing but the reverse of P/E ratio.

Now here are the reasons why Dividend Yield is an important metric for investors

The higher dividend yield determines whether the market is overpriced or underpriced.

Also, in comparison to other metrics such as P/E or P/BV, the dividend yield is a more stable measure.

In case the dividend yield is attractive it also points to the fact that the prices shall not fall below some level.

Why one should overlook the dividend factor?

Stocks with high dividend yield tend to underperform those with low yield. And now we'll understand why we should avoid the dividend metric:

1. Higher dividend yield offers less of investment oppounities:

These companies offering higher dividend yield are stable businesses that offer limited growth as well as investment opportunity. So, this is one reason why a larger chunk of the companies' profits are paid out as dividend to investors. In fact from the valuation front too, ROE and growth prospects are an important parameter in contrast to stable dividends.

2. High dividend yield is more a result of weak prices:

For stocks with high dividend yield will less of opportunity, you do not appreciation in stock price and when the prices fall, the dividend yield becomes all the more attractive. Also, high dividend yield is a result of the lack of traction in stock prices that is not a good thing for investors.

3. More buyback also tend to erode the significance of dividend yield:

As dividend over Rs. 10 lakh were previously taxed at the rate of 10 percent, so more of companies came out with buyback offer instead of higher dividends.
Now, these high dividend yielding stocks also tend to have high earnings yield too. Given that as the P/E ratio is the reverse of the earnings yield, this is indicative of a low P/E ratio. This is the reason why high dividend yielding stocks are offered at a cheap valuation. Now this low P/E suggest low growth opportunities as well as limited value creation potential in comparison to a sign of stock being underpriced. Now, the next time, you pick a stock solely on the basis of high dividend yield, please exercise caution as you may be getting stuck into the dividend trap.

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