Q: If looking for income, shouldn't I just buy stocks with the highest dividend yields?

Intuitively, from an investor standpoint, you'd want to own stock in companies with high dividend yields (the dividend yield is calculated by dividing the annual dividend per share by the company's stock price).

High is a relative term, though, so let's consider a dividend yield on a stock that approximates the yield on the 10-yr Treasury note (currently 4.78%) as being on the high end. As a secondary reference, note that the current dividend yield for the S&P 500 is 1.76%.

It isn't advisable simply to bite on the hook of a high dividend yield. More often than not, high dividend yields go hand-in-hand with low stock prices that are the result of a company providing some source of disappointment (eg. earnings miss, sales shortfall, SEC investigation, etc.).

This isn't always the case, but in looking at a stock with a high dividend yield, one should understand the reason for that disposition. Is it the result of a disappointment of some sort that you think has been adequately discounted?  Is it just a function of a broader market decline? Is it little more than an enticement by a mature company with low growth prospects?

Consider, too, that dividend payments can be slashed at the board's discretion.  Accordingly, what appears to be a high-yielder one day could be a low yielder the next.  A case in point is Friedman Billings Ramsey (FBR), which qualifies as a mortgage REIT.

In the first quarter last year FBR paid a regular cash dividend of $0.20 per share.  At the record date of March 31, FBR's stock was trading at roughly $9.25 per share.  The corresponding dividend yield was 8.65%.  In September, however, the regular cash dividend was slashed to $0.05 per share, and now, FBR's dividend yield is a more pedestrian 2.65%.

Ford (F) provides us another example that dividend payments can be changed - or in Ford's case, discontinued altogether - due to business conditions.

In the first quarter last year, Ford's dividend was $0.10 per share.  With its stock trading at $6.91 on the May 2 record date, its dividend yield stood at 5.79%.  On September 15, Ford discontinued its dividend.

Another question that should be asked in the pursuit of dividend paying companies is, does the company have room to increase its dividend? The answer to that question can be found in the payout ratio, which is determined by dividing the amount of dividends paid by the company's net income.

All else equal, a company with a payout ratio of 30% has more room to raise its dividend, and presumably is at less risk of cutting its dividend, than a company with a payout ratio of 70%. An apples-to-apples comparison of the payout ratio, however, can't be made across industry groups.

For instance, a utility company and a technology company are entirely different in terms of their business and growth prospects. Therefore, one must look within the industry group to determine where the most opportunity exists in terms of increasing dividends. A 55% payout ratio for a utility company is high vis-a-vis a technology company with a payout ratio of 20%, but if other utility companies have a payout ratio that exceeds 65%, an income investor might find the utility company with the lower payout ratio to be the more prospective dividend play within the utility sector.

--Patrick J. O'Hare, Briefing.com