Forget yield. You can have a great retirement without it

We get hundreds of questions from members but there's a particular type that shows up over and over: "Company XYZ is trading with a dividend yield of 10%. Is this a buying opportunity?"

If there's one ratio that leads investors astray more than any other, it's a stock's dividend yield. It's simple to calculate - the most recent annual dividend divided by the current share price - and it has some major advantages over other valuation techniques. Dividends are real cash delivered to your bank account, not a mystical earnings figure reported by the company and prone to accounting manipulations. 

There's evidence that buying a basket of stocks with above-average dividend yields tends to outperform the overall market. Our own experience weaves a similar tale - since inception in 2001, our Model Income Portfolio has returned 12.6% a year, whereas our Model Growth Portfolio has returned 9.9% (both outperformed the overall market return of 8.1%).

Nonetheless, focusing solely on the dividend yield is a really good way to land yourself in trouble. For one thing, the dividend yield is a historical measure. When you buy a stock, though, the only thing that matters is what will happen in the future. 

Business risk can surface in many ways, with a big one being the company's financial strength and balance sheet - even a great company may be riskier than a mediocre one if it's loaded with debt. A company's competitive position and ability to generate cash are also important. Business risks of one form or another are the main reason we've stayed away from seemingly attractive yield stocks like Transurban, AMP and AGL Energy.

What's more, the dividend yield is unrelated to a company's ability to grow. If anything, a high payout ratio could indicate a company has fewer opportunities to reinvest profits. A declining dividend or payout ratio may actually be a good sign if it means management is allocating more resources to acquisitions or expansion projects.  

The importance of total return

If you're a retiree, you may be thinking: 'The cruise line won't accept paper gains when I go to buy a ticket; they want cash. And that takes a dividend.'  

It may seem counterintuitive, but buying a high-quality growing company with a modest dividend yield could still be your best option. 

In February 2016, we recommended members buy Ansell after a profit downgrade. The stock had an unassuming dividend yield of 4%. What we liked about the company, however, was that it owned a collection of well-recognised brands, had a large and entrenched distribution network, economies of scale, and we liked that the company was buying back stock at attractive prices. Our upgrade paid off: earnings have risen 20% since then, and the market is now excited by the company's turnaround. 

Stepping back to 2016, let's say that you needed a 7% yield to fund your retirement. You had two options: find a stock that pays 7% - and probably carries significant business risk if it trades at that price - or you could accept Ansell's 4% yield and then sell 3% of your holding each year. Either way, you're getting your 7% cash in the bank.

If you had followed the latter method, your Ansell shareholding would have shrunk by around 10% since then but the growth in intrinsic value per share (thanks to the 20% earnings growth and improving outlook) has more than offset the declining number of shares you own. In fact, Ansell's share price has risen 75% over that time. Not only did you get your 7% yield, you got bumper capital growth too.

When considering which stocks to add to your portfolio, the current dividend yield should only be one factor in your decision because you can pay for your living expenses from both dividends and stock sales. Investing in high-quality, undervalued companies that offer a reasonable dividend and decent growth prospects is a much better strategy than only buying high-yield stocks.