Yesterday, I met with a best friend who told me that now he has decided to learn more about the stock market and to invest in stocks that he is retired. One of the strategies he decided to pursue is to invest in high dividend yield stocks. I told him that was not a good idea, and continued to explain why.

After giving my advice, it occurred to me that perhaps the help that I gave my best friend might be help that I might give others as well; hence I decided to get back to writing a blog, after almost three years of absence.

First of all, before even investing in a high dividend stock, one has to evaluate the likelihood that management will continue paying the same rate of dividends, or for that matter will continue paying dividends at all. Look at the company’s payout ratio- what portion of the earnings are being paid out as dividends? If the payout ratio is increasing, reaching 100% or greater, there is a great likelihood dividends will be stopped or be reduced. After all, how can dividends be paid when the company is not making enough to pay them?

I also told my friend that Nobel Prize winners Merton Miller and Franco Modigiliani showed that there is no correlation between high dividend paying stocks and high return on investment. And since what you are really after is the highest possible profit on your investment, then high dividend paying stocks do not necessarily lead you into achieving your objective.

Do you know that when a dividend is paid, the value of the stock goes down by the amount of dividends paid? So theoretically, receiving a dividend does not really increase your profits. It is just converts some of your capital gains into dividends.

Furthermore, to me, by paying a high dividend rate, management tacitly admits that the company has limited prospect for growth. As such, capital that would normally be used to support growth is not needed, and consequently could be returned to stockholders as dividends. Obviously, a company that does not grow more likely will not generate the highest possible profit on your investment.
But what about my friend’s concern that he needs the dividends for his living expenses, now that he is retired? Well, after he has invested in stocks that go up in value, he could cash in his profits by regularly selling some of his shares.