December 14, 2009

Is High Yield Stock a Bargain or a Warning Sign?

What do GM and Citigroup have in common? They are both components of the Dow Jones Industrial Average, they both paid dividends of over 4% in 2008 and they both lost 90% of their value since Jan. 2008. So lets say you were shopping for stocks in early 2008 and you figured that Dow stocks should be a safe bet. You might filter the Dow for undervalued stocks by looking at the higher yielding stocks. These stocks might have seemed like a relatively safe bargain a couple years ago but both turned out to be flops.

If a stock price drops then the yield % goes up. So a Dow component with a high yield might be viewed as a good value. On the other hand a high yield may be a reflection of a stock who's price has been declining yet still has a relatively high trailing dividend. A stock in trouble may be destined for bankruptcy or it may be due for a cut in dividends. A high dividend yield may be fools gold.

The bottom line is that a high dividend on a stock isn't alone an indication that the stock is a good value. High dividends could be reflection of a stock that is in trouble. You should take caution when picking high dividend stocks to make sure they have sound financials.

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