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Don’t let this blue-chip’s juicy dividend yield fool you

With interest rates sitting at just 2.5% (and possibly heading even lower), you can’t blame investors for going after solid Aussie blue-chip stocks which offer juicy, fully franked dividends. Indeed, I own a number of them myself…

But there is a fine line between investing for dividends and investing in stocks which offer great dividends. And that is a lesson often not understood by investors.

As a perfect example, I invested in Coca-Cola Amatil Ltd (ASX: CCL) recently because, at $9.39, I loved the company’s prospects and believed I was paying a very good price for such a high quality company. Of course, its estimated 4.9% dividend yield attracted me too, but it was the business itself and its future prospects that got me over the line.

Right now though, it is becoming increasingly obvious that there are a number of blue-chip stocks being sought after by investors, mainly thanks to their lucrative dividends. That is, the stocks themselves are widely considered to be overpriced and are expected to deliver sub-par returns in the medium-to-long run, yet they continue to be targeted by income-hungry investors.

Commonwealth Bank of Australia (ASX: CBA) is one such stock. At $80.90 per share, it appears to be “priced for perfection”, trading on a projected P/E multiple of 15.1 and a Price-Book ratio of 2.9. In fact, by most measures, it is one of the most expensive banks in the world.

At that price, it seems like investors are under the impression the bank can continue to rapidly grow earnings over the coming years, but in reality, that is highly unlikely. To begin with, its record profitability is largely a result of the low interest rates and resultant low bad debt charges. Once interest rates rise, that could becoming increasingly difficult.

Despite the fact that Commonwealth Bank remains one of Australia’s highest quality corporations, it is by no means a good buy today, and yet the stock still continues to trade at around $81.00 (just below its all-time high)…

It is becoming increasingly apparent that the bank’s 4.9% fully franked dividend yield is playing a key role in keeping the price at such an elevated level. Grossed up, that’s a massive 7% yield which far outweighs the returns from “risk free” investments like term deposits. The bank’s primary rivals, namely National Australia Bank Ltd (ASX: NAB), Australia and New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corp (ASX: WBC) are also in the same boat at their current valuations.

The thing that investors need to understand is that they should never invest in a company based purely on their dividend yield. Sure, it can be a contributing factor to your investment thesis (just like Coca-Cola Amatil’s yield was with mine), but relying on it too heavily could prove disastrous in the long run. For instance, given CBA’s high valuation right now, its 7% grossed up yield could be more than offset if the stock were to fall in price, which would leave you with a capital loss.

Invest in this ASX dividend stock before CBA.

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