Rising Dividend Yields: 3 Red Flags

Companies that increase their dividend yield—commonly calculated by dividing annual dividend payments by the current share price—are typically considered to be financially sound. But sometimes a rising yield can be a distress signal.

"If the yield rises and the share price is constant or rising, the company has increased its dividend payment—a good sign," says Adam Lynch, director of equity research at the Schwab Center for Financial Research. "However, if the yield rises and the dividend remains the same, the stock price had to have fallen—often not a good sign."

In evaluating whether a stock's dividend yield is problematic, look out for:

This threshold historically has marked the difference between sustainable and unsustainable yields. Indeed, research conducted by Schwab Equity Ratings^® found that large-cap dividend payers with a median yield of 4.1% are nearly twice as likely to cut their dividend as those with median yields of 2.3% or less.

Among U.S. large caps, companies with higher median dividend yields historically have had a greater likelihood of cutting their payouts.

This measure reveals the number of times a company can pay its current level of dividends out of its net income. Ideally, this figure is above 2 (or 200% of net income); dipping below 1.5 (or 150% of net income) suggests a dividend cut may be forthcoming.

This metric tells you what percentage of a company's net income is paid to shareholders as dividends. When it creeps above 80%, the company may not have much left over to invest in growth or pay down debt—which could indicate a weakening financial position.

"The sector in which a company operates can also help you interpret if an increase in yield is cause for concern," Adam says. Financials and utilities, for example, are known as dependable dividend payers, so you might not be as worried by price volatility that pushes their yields up. Conversely, real estate investment trusts (REITs)—which represent a significant share of the real estate market—must pay out 90% of their income to shareholders. Thus, a significant increase often is the result of a falling share price, since most REITs don't have much room to grow their dividends organically.

"Regardless of sector, if you're holding a stock specifically for its dividends and the yield rises sharply, you might want to investigate the cause," Adam says.