Dividend investors often set their sights on the highest yields. But therein lies a trap, experts say.
A stock's dividend yield is the amount of the annual dividend divided by the share price; so when the stock's price falls, its yield rises. Also, dividend yields don't indicate how expensive a stock is relative to the company’s earnings.
The popularity of stocks with the highest dividend yields has caused many of their price-earnings ratios to jump. Consider Duke Energy (DUK), a utility with a 4.4 percent yield. It trades at 22 times its earnings per share over the last 12 months. That's higher than its 5-year average of 18 times earnings.
Not only that, Duke's P/E ratio is now above the Standard & Poor's 500 index’s ratio of 15. At the end of 2009, it was roughly the same as the market's. This follows a similar pattern for many of the highest-yielding companies. After trading with P/E ratios lower than the market for more than a decade, the highest- yielding stocks in the S&P 500 now have a higher P/E ratio, says Chris Petrosino of the quantitative strategies group at Manning & Napier.
For stocks with attractive yields and P/E ratios, investors are advised to look outside of the top tier of dividend payers. Within a ranking of the S&P 500 by dividend yield, the stocks ranked 101 through 200 on average are still trading at lower P/E ratios than the S&P 500.Associated Press