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Is this stock’s 7.5% dividend 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. Although it might play a big part in the final decision, there are so many other factors that also need to be considered before you press that “Buy” button.

Commonwealth Bank of Australia (ASX: CBA) is a perfect example of this. While the stock has fallen more than 9% since peaking in July, many investors have been wondering whether now is the time to pounce and take advantage of its tantalising $4.01 per share dividend. At $76.34, that’s a grossed up yield of 7.5%!

Indeed, in this low interest rate environment, that yield is far better than what investors could expect to receive in interest from term deposits or from government bonds. However, those investors who choose to buy now could also be committing themselves to years of underperformance.

Even at today’s lower price, the stock still demands an excessive premium. Although the dividend might be attractive, I’d be willing to bet that the capital returns will be very limited in the coming years. Who knows, with all the risks facing the financial sector, maybe we’ll even see the shares drop considerably over the next few years.

For example, investors need to weigh up whether the inflated housing market or the tumbling Aussie dollar will impact the share price. Likewise, they need to consider whether new capital requirements that are likely to be imposed on the big four banks will change CBA’s ability to grow or even maintain its current dividend payments.

When these factors are considered, is it really worth taking the risk for what could potentially be a very small capital return?

As it stands, Commonwealth Bank of Australia is trading on a P/E ratio of 14.4. Although that is lower than the market’s average (roughly 15.3), it is still excessive considering the bank’s limited growth opportunities in the coming years. Given the headwinds facing the sector, investors who choose to buy Commonwealth Bank now for its lucrative dividend could be in for a rude surprise in the future.

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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