"The yield is 9%!" — Famous last words. How do you evaluate whether a high yield is sustainable?
Had a conversation with a colleague last week who was excited about a stock yielding 9.3%. "Free money," he called it. I've made that mistake enough times to know better, but it got me thinking about how I actually evaluate high yields now.
The quick filters I use:
Payout ratio sanity check. If a company is paying out more than 75% of earnings as dividends (or more than 80% of free cash flow), there's not much margin for error. One bad quarter and that dividend is at risk. Exception: REITs and MLPs have different economics and often legitimately pay out 90%+.
Dividend coverage from cash, not accounting earnings. Earnings can be manipulated with accruals. Free cash flow is harder to fake. I want to see dividends covered at least 1.25x by FCF over multiple years, not just the most recent quarter.
Why is the yield so high? This is the key question. Yield = dividend / price. A high yield can mean:
The dividend is genuinely generous (rare but possible)
The price has dropped because the market expects a cut (common)
The price has dropped for reasons unrelated to the dividend (opportunity)
It's a sector where high yields are normal (utilities, REITs, tobacco)
You need to figure out which one you're looking at. If the price has dropped 40% in six months and the yield has spiked accordingly, the market is telling you something.
Check the history during stress periods. What did the company do during 2008-2009? During 2020? Did they maintain, cut, or suspend? A company that maintained through multiple crises has demonstrated commitment. A company that cut at the first sign of trouble will probably do it again.
Debt levels matter enormously. Dividends are paid after debt service. A company with a 9% yield and a debt-to-equity ratio of 3x is one refinancing crisis away from cutting. I got burned badly by this with some energy MLPs that had unsustainable capital structures.
The sectors where high yields can be legitimate:
Tobacco (mature industry, pricing power, declining volumes offset by price increases)
Utilities (regulated returns, predictable cash flows)
REITs (legally required to distribute 90% of income)
Some telecoms and energy infrastructure
The sectors where high yields are usually traps:
Retail (structural decline, thin margins)
Offshore drilling, coal (secular decline)
Small banks with concentrated loan books
Anything where the high yield is recent and unexplained
My personal rule: if the yield is above 6%, I need to understand exactly why and have a specific thesis for why the market is wrong. If I can't articulate it, I don't buy it.
What's your process for evaluating high yielders? Anyone been burned recently by a yield trap they want to share?
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