The financial crisis is seemingly behind us, and the markets have hit all-time highs in recent months. You might think this would be a perfect setup for some opportunistic investors to hunt for that next “hot” stock, but some evidence reveals quite the opposite: Investors are generally looking for what they deem to be safer, more reliable investments.

Since the financial crisis, investors are clearly becoming more concerned about putting their money in a “safe” stock that pays regular dividends rather than chasing a “hot” stock they hope will triple overnight.

So, what’s the problem?

Companies that pay dividends are typically more stable, mature firms. And in general, these dividend paying stocks can be a great way for investors to get started when looking for investment opportunities. But investors that chase high yield/dividends may be ignoring a key piece of information when pursuing “safety” in a high-dividend stock. In such a case, it may be that investors are concentrating on the payout and forgetting about the price of the stock in relation to the company’s performance. A little background about stock valuation may help to see this:

Factors in Stock Valuation

It’s important to remember that when investing in a stock, you are actually purchasing a fractional ownership interest in that company (the dividend is only part of the equation). What are you primarily concerned about when you purchase a company? If you’re a long-term investor, you’re concerned about how much money the company is earning today and how much the company earns in the future.

Since how much a company is earning of the primary interest to an owner, it is useful to examine the price-to-earnings ratio (P/E). The P/E ratio tells you how much you have to pay (the price) for each $1 of earnings the company is currently generating. After all, you don’t want to pay too much for something, right? Following that line of thought, you wouldn’t want to purchase a stock with a very high P/E ratio relative to other similar stocks. For example, all else equal, you wouldn’t want to buy stock A that has a P/E ratio of 20/1 when you could buy stock B with a P/E of 10/1. You would be paying $20 for every $1 of earnings from stock A, but just $10 for every $1 of earnings from stock B.

But current earnings are only half of the equation. Remember, both current and expected future earnings are inputs when determining the value of a company (i.e., the price of a stock). Theoretically, a company could have a high price (due to high expected future earnings) even though they have little earnings today. This would result in a relatively high P/E ratio.

Dividends vs. Investing in Future Growth

This concept is important to the discussion of high-dividend stocks. When a company pays out a large fraction of its earnings, it retains very little for investing for future growth. Therefore, high-dividend stocks tend to not generate high future earnings growth compared to companies that do not pay dividends. High-dividend stocks historically have lower P/E ratios than non-dividend paying stocks, because non-dividend paying stocks are generally reinvesting their earnings in order to generate higher earnings in the future, and the market is factoring in the higher expected future earnings into the price of the stock. This results in a higher price relative to current earnings, as compared to high-dividend stocks.

The opposite is true today. High-dividend paying stocks have significantly higher P/E ratios than non-dividend paying stocks, meaning they appear to be overpriced relative to their earnings. It appears investors might be blinded by the apparent safety of a receiving a dividend today, and that they have forgotten that a dividend is only a fraction of a company’s current earnings. In an ideal world, investors would be concerned about both current and future earnings.

Even though investing in stocks that pay a high dividend may seem like a safe investment, this may not be so if the stock is overvalued or if the company’s health is deteriorating, which could lead to a stoppage of dividend payments and a devalued stock price. A better approach may be to ignore the dividends and concentrate on the health of the company and valuation of the stock when investing for the long term.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time. Stock investing involves risk, including possible loss of principal.