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Income Investors: Are You Overpaying for Dividend Yield?

Many income investors make the costly mistake of chasing high yields without considering the value and long-term growth trajectories of the businesses behind the stocks. For retirees, high dividend yields may be the only way to truly get a raise, but I believe a great deal of due diligence needs to be done before any sort of investment decision is made, especially since a lot of dividend stocks with yields higher than their historical averages could come with a lot of extra baggage that investors may not have thought about prior to hitting the buy button.

I believe income investors should take a page out of Warren Buffett’s handbook and consider the value they’ll receive before they buy a stock just because of an attractive dividend yield. Even if the dividend is safe, more homework needs to be done to ensure capital gains and dividend growth will be solid over the long haul.

Many income investors are too focused on the yield, and as a result, their total long-term returns will suffer, since a lot of the time these investors will overpay to get their high yield. What good are huge dividend yields if lacklustre capital gains bring down the total return in the long run?

Many businesses with high-yield stocks are known as slow-growth stocks, but that doesn’t mean you should ignore their growth profile. In fact, analyzing a company’s growth prospects is just as important for potential income investments, as it is with growth investing. Fortunately for income investors, the growth profiles of high-income-paying companies are much easier to predict and understand.

Why is it important to analyze growth for an income investment?

A business with a promising growth profile means the dividend will likely grow at a higher rate over the course of many years. In addition, high capital gains are to be expected as well, which you should treat as a bonus as an income-oriented investor.

Consider Northland Power Inc. (TSX:NPI), an independent renewable power producer which develops, builds, owns, and operates “clean and green” energy production facilities. The stock has a solid ~4.56% dividend yield and a very promising growth profile.

The company’s payout ratio was stretched in the past but is now back down to earth at 70% levels thanks in part to contributions from recently completed renewable projects, including Gemini.

Northland Power has a strong contracted pipeline, which will translate into further growth and potential dividend hikes down the road. At a 15.61 price-to-earnings multiple, Northland Power is a very attractively valued high-yield stock with a sound growth profile and the potential to become a dividend-growth player in the future, despite having a static dividend for many years in the past.

Stay hungry. Stay Foolish.

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Fool contributor Joey Frenette has no position in any stocks mentioned.

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