With interest rates at historic lows (the 10-year Treasury yielding a paltry 3.7 percent), it’s natural for investors to search for higher yields. Dividends are the typical place for investors to begin their quest. But are all dividends the same? Are all dividends inherently “good?”

Most people think that dividends are in and of themselves good things. This is a myth. There is good yield and there is bad yield.

Most people think that dividends are in and of themselves good things. This is a myth. There is good yield and there is bad yield.

It is vitally important to know the difference at all times, but even more so in market environ­ments such as today where many product makers are pushing and investors are reaching long and far for high yield. It’s not the fact that a company does pay a dividend which is meaningful; it’s the fact that it can. I’ll explain.

You’ve no doubt heard the expression “If it sounds too good to be true, it probably is.” Well in the world of investing, if it sounds too good to be true, it definitely is.

Often, periodicals such as the Wall Street Journal (WSJ) or Barron’s will print a table of high-yielding securities and you will occasionally find listed compa­nies and funds paying out 10 percent or more. It is very important to dig deeper to determine the source of this yield. There are two major red flags you should look for.

The first is, when a company’s earnings do not adequately cover its distributions. To assess this, look at the company’s payout ratio which is the dividend per share dividend by a company’s earnings per share.

This important statistic readily available on most financial research sites indicates how likely the company is to continue to pay — or to increase — its dividend over time.

A payout ratio of less than 50 percent is preferable. If a company’s pay­out ratio starts heading north of 70 percent due to a decline in earnings (by definition if earnings are shrinking and dividends are constant, the payout ratio will increase), this is a sign that the company may be getting ready to cut its dividend.

And if its payout ratio is over 100 percent for several quarters, proceed with extreme caution! This scenario is not sustainable. A company cannot forever finance a dividend payment if it is not making more money than it is paying out – plain and simple. Stay away from these companies as the last thing you want to do is buy into a company just before it slashes its dividend.

Another scenario for a potentially suspect high-yielding security is a fund that makes a so-called “controlled payout.” An example would be a fund trading at $10 per share fixing its dividend payout at $1.30 per share so that the fund yields 13 percent.

In most cases, however, the fund or the underlying securities it holds, are not earning enough to cover the dividend. So how is the fund paying a dividend, you ask?

The fund is simply return­ing principal slowly to shareholders over time! As an example, let’s say a promoter advertised an investment that guaranteed a 20 percent annual dividend stream. Sounds too good to be true, right? Definitely.

You give him $100 and for five consecutive years he hands you back $20. If he is not earning more on the original money than he is returning to you in the form of a “dividend” then eventually the money runs out and the game is over. The 20 percent yield provided a total return on invest­ment (ROI) of precisely 0 percent. This is the bad kind of yield.

Buyer beware. The mere fact that a company or fund pays a dividend is not praiseworthy. It’s important to know how a company is paying its dividend. Look for companies that are financing their dividend through continued earnings growth and solid financials, and steer clear of those companies with abnormally large payout ratios.

Dividends can be a great source of income in this low interest rate environment. Be smart and those checks will keep coming.

Scott Kyle is the CEO and Chief Investment Officer of Coastwise Capital Group, LLC, a boutique money management firm headquartered in La Jolla, California and named La Jolla’s Top Financial Advisor in the La Jolla Light’s 2009 “Best of La Jolla” poll as well as a 2010 Five Star Wealth Manager featured in San Diego Magazine. Scott is also author of the book, The Power Curve: Smart Investing Using Dividends, Options, and the Magic of Compounding. Contact Scott via email at info@coastwisegroup.com. Coastwise Capital Group is a registered investment advisor located in La Jolla, California. Coastwise Capital Group may only transact business in those states or countries in which it is registered, or qualifies for an exemption or exclusion from registration requirements. The information contained in this publication is strictly for educational and illustrative purposes and is not an attempt to furnish personalized investment advice or services.

Tags: 10-year Treasury, Barron's, Investing for income, Investing yields, SDNN, wall street journal, Yields

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