When someone brags that their stocks are paying really high dividends, make sure you put a filter on what you’re hearing. Because there’s more than one way to interpret such a boast, and only one of them counts.
Is one dollar per share a high dividend? Well, it depends on something else entirely – it depends on what the stock is worth.
If the stock is selling for $5 per share, then yeah, that $1 is a darn high dividend. Because it means the return on investment is a whopping 20%.
But there’s another question you need to ask, too. Is the amount being quoted the annual dividend, or the quarterly dividend payment?
The Ying and Yang of High Dividends
Take that $5 stock paying the $1 dividend. In the real world you wouldn’t need to ask, that would easily be interpreted as an annual dividend. Because it’s virtually impossible for a $5 stock to pay a $4 annual dividend, based on $1 per quarter.
Why is that impossible? Because the market will always price a dividend paying stock (through the forces of supply and demand) to compare to expectations and what’s reasonable in the current economy. Nobody pays an 80% return, because nobody has to. And if they do, the company is so ridiculously risky (they’d have to dangle that carrot to get anyone to considering investing) it wouldn’t be in the market in the first place.
If, in that example, the company really did pay out $1 per quarter, or $4 annually, the market price of the stock would probably be around $80 per share, maybe even more depending on the level of risk, which is a 5% return. This is an amount that competes with other investments at the same risk level.
The Nature Forces of the Market
This is the miracle of the stock market – prices are naturally set through supply and demand, which in turn is driven by the going rate for investments at a given level of risk.
That’s why the market responds to news – news affects supply and demand, which immediately is reflected in the prevailing price.
There are no bargains the market, as a general rule, because the market prices stocks through this phenomenon based on a combination of current performance and the perception of future prospects. In effect, your investment is based on whether you believe those forecasts, or not.
Going back to our example, what if that $1 per share dividend was coming from a company selling for $50 per share? That’s only a 2% return, which isn’t high at all compared to a company whose shares are selling for, say, $10, in which case the $1 dividend is a 10% return.
Why then, you might ask, aren’t all company selling at prices that deliver the about the same rate of return?
The Role of Risk
Because not all companies offer the same level of safety, both near term and in the future. A plethora of variables combine to determine the market’s assessment of a company’s worth, some relevant, some not.
Dividends are a key part of that equation, but not remotely the only part. As an investor, your job is to balance your needs (risk vs. reward, annual return versus future growth potential) with your belief in the company going forward.
Nobody has all those answers. Which is why any investment is something short of a sure thing. But you can come close, especially when it comes to investing for high dividends.
Because high dividend stocks are traditionally more stable than lower or no dividend stocks. That’s precisely why they pay a high dividend – they aren’t moving in any direction very quickly.
