Is this blue-chip’s 7% yield too good to be true?

One of the most important lessons an investor can learn is to never base a decision solely around a stock’s dividend yield.

Commonwealth Bank of Australia (ASX: CBA) announced a final dividend of $2.18 per share when it reported on Wednesday, taking its full-year dividend to $4.01 per share. At today’s price of $81.32, the stock is trading on a fully franked yield of 4.9% or, grossed up, a yield of 7%.

That yield is sure to attract plenty of income-focused investors given the current low interest rate environment, which has rates stuck at just 2.5%. However, those investors who choose to buy now could be committing themselves to years of underperformance.

Sure, the dividends paid in that time should be handsome, but given the company’s sky-high valuation, I’m betting the capital returns will be very limited in the coming years. Maybe we’ll even see the shares drop in price in that time…

Already we saw a number of concerning signs in the bank’s earnings report. While its $8.7 billion profit blew the market away, the shares fell on various other numbers, including a flat net interest margin caused by increasing levels of competition across the sector.

Rising bad debt figures in the latest quarter were also concerning. Low bad debt charges have been one of the driving forces behind all of the big four banks’ record profits in recent times and some analysts are suggesting they could soon start to rise.

Currently, Commonwealth Bank of Australia is trading on a P/E ratio of 15.3x making it more expensive than any of its major rivals (in fact, by most measures it is the most expensive bank stock in the world). While earnings growth could come under pressure in the near future, and Commonwealth Bank shareholders could be in for a rude surprise.

A much better dividend pick than Commonwealth Bank

As I’ve said before, there is no point in buying a stock for its great dividend yield if its share price is likely to tumble.

The Motley Fool's top analyst, Scott Phillips, has recently unveiled his top dividend pick for 2014 - 2015, which not only offers a fat, fully franked dividend yield but also solid growth prospects. This promising ASX stock could be a huge winner for your portfolio over the coming years, and you can discover the name and code FREE by clicking here now.

Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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