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When Fantastic Dividend Yields Are Too Good to Be True

Over the past few years, the investing landscape has come to be dominated by dividend-paying stocks. Investors looking for a higher probability of making a profit realized that companies making and sharing profits with stockholders would do very well over time.

Over the past few years, interest rates have remained relatively low, while share prices have increased in value. Numerous companies have increased their dividends with good reasons.

For a company, the capital employed in the business can come from one of two sources: equities or bonds. Traditionally, bonds have paid a rate of interest that was substantially higher than the dividend yield of any company (even when calculated on a post-tax basis). The result was that it made more sense to pay down debt prior to repurchasing shares or increasing dividends. Post-2009, things changed. Interest rates declined substantially, and companies can now borrow money for less than the dividend yield offered on their shares.

With a changing cost of capital, many companies have been successful in issuing more debt while paying no more in total interest cost and buying back shares. Once shares have been retired, there are fewer shares used in the calculation of earnings per share, and the dividends paid per share need to be increased to maintain the same total dollar payout. Shareholders have been huge winners in this low interest rate environment.

The challenge facing investors is finding the companies that offer excellent dividend yields without taking on too much debt, which would make the dividends unsustainable over time. Case in point: Just Energy Group Inc. (TSX:JE)(NYSE:JE). The company, which provides electricity, natural gas, and water heaters to consumers at a fixed rate, is currently offering investors a dividend yield of more than 7.25%.

Just Energy cut the dividend in 2015 and then again in 2016. The company has seen the balance sheet shrink amid declining revenues both year over year and quarter over quarter for the most recent fiscal year and quarter. Although many investors bought shares for the high dividend yield with the hopes of realizing some capital appreciation, the reality has been far worse.

Over the past year, shares have declined by more than 10%, which pales in comparison to the five-year decline of almost 40%. For investors purchasing shares in any company (even the dividend-paying ones), it is still essential to analyze the company fundamentals and long-term sustainability of the business model.

Invest wisely!

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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