High dividend yields and low P/E ratios are two signs that you need to research a stock very thoroughly before investing in it.

“You get what you pay for” is a worthwhile tidbit of investment advice. But to profit from it, you have to understand how to apply it. The adage should come to mind whenever you come across a stock that seems extraordinarily low-priced and has an extraordinarily high dividend yield. The you-get-what-you-pay-for rule tells you there may be a hidden reason for an unusually high dividend yield—just as there may be a hidden reason for a very low P/E ratio.

Unusually high dividend yields can be an indicator that a company may report poor earnings—and that investors anticipate a subsequent dividend cut.

One major indicator is a suspiciously low price/earnings ratio. This makes us doubt the quality of its earnings. (The P/E is lower than average because “P” is the numerator or upper figure in the ratio.)

For example, suppose you find a stock with a P/E (per-share price-to-earnings) ratio of, say, 6.0, at a time when seemingly comparable stocks are selling at P/Es of 12.0 or 15.0.

This lower stock price can also result in an above-average dividend yield. The formula for dividend yield is D (dividend)/P (stock price). The yield goes up because the P or price is depressed and it’s the denominator or lower figure in the ratio.

In both cases, investors have reason to doubt the quality or sustainability of the company’s earnings or dividend. The reason may be good or bad. Either way, you get to buy a stock at what looks like a bargain. That is, you pay a lower price in relation to the stock’s earnings and dividends—lower than prices for comparable stocks.

When researching stocks with low P/E ratios or a high dividend yields, you need to do two things:

First, figure out why investors have doubts about the stock; second, decide if the reasons for these doubts make sense. Remember, stocks can go in and out of favour with investors for bad reasons as well as good ones.

So, to profit from “you get what you pay for,” you need to tack on six extra words: “…but only if you shop carefully.”

Note that shopping is only possible when you have a variety of stocks to compare. You can only spot a discounted price if investors are putting varying prices on stocks that are otherwise comparable.

Investment products are in a different category. The promoters or sponsors of these products generally offer them at set prices, rather than subject them to competitive bidding by investors.

We’ve always placed a high value on dividend stock investing, mainly because it provides something of a pedigree for stocks we recommend. After all, you can’t fake a record of dividends.

It takes a lot of success and high-quality management for a company to have the cash flow to continually declare and pay a dividend every year for five or 10 years or more.

Here’s the biggest risk with high dividend yields

When looking for stocks with high dividend yields, you should avoid the temptation of seeking out stocks with the highest yield—simply because they have above-average yields.

That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend.

Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks that have a high dividend yield that they have maintained or raised with their dividends during a recession or stock-market downturn. That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.

A track record of dividend payments is a strong sign of reliability and a strong indication that investing in the stock be profitable for you in the future.

Have you found your investments with high dividend yields to be profitable? Has one ever turned out to be a dud? What happened? Share your story with us in the comments.