Understanding Dividend Yield Stocks

Investors seeking investments offering regular income may consider high-dividend stocks as an investment choice. Dividend stocks pay a percentage of a company’s earnings to shareholders consistently.

Many U.S. dividend stocks pay shareholders a specific amount quarterly. Over time, top dividend stocks increase these payouts so shareholders can establish an annuity-like cash stream. Shareholders may also elect to reinvest their dividends.

Dividend stocks are generally less volatile than growth stocks, meaning they can help diversify investment portfolios and reduce the risk.

Key Takeaways

  • Stock dividend yield measures the cash flow an investor receives for every dollar they invest in an equity position.
  • Evidence shows that historically focusing on dividends typically increases returns rather than slowing them down.
  • While high dividends are attractive, they might be at the expense of a company’s potential growth.
  • When investing in dividend stocks, investors need to find a dividend stock, evaluate the stock, and determine how much of it to purchase.
  • In addition to dividend yield, investors should consider dividend growth, financial strength, dividend stability, competitive advantages, and growth prospects.

Understanding Dividend Yield

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Stocks dividend yield measures the cash flow you’re receiving for every dollar invested in an equity position. Essentially, dividend stock yield is how much of a return you’re getting on for an investment stock without any capital gains.

Say Company XYZ trades at $30 and pays annual dividends of $3 per share to shareholders. At the same time, Company ABC’s stock is selling for $60 a share and also pays yearly dividends of $2 per share.

The dividend yield for Company XYZ is 10% (3 ÷ 30), while the dividend yield for Company ABC is only 5% (3 ÷ 60). If all other factors are the same, investors wanting to use their investment portfolio to supplement their income likely would prefer XYZ’s stock since its dividend yield is double that of ABC’s.

Stocks that pay high, stable dividend yields are great for investors needing a minimum cash flow from stock investments. Well-established, older companies generally pay out a higher percentage of dividends than new, less-established companies. The dividend history of established companies is also typically more consistent.

Advantages of Dividend Yields

Historically, evidence suggests that focusing on dividends can amplify returns instead of slowing them down. For instance, since 1970, 78% of S&P 500 total returns are from dividends, according to Hartford Funds analysts. This assumption is because investors will likely reinvest dividends back into the S&P 500. This then compounds the investor’s ability to receive more dividends in the future. For example, suppose an investor purchases $30,000 worth of a security with a dividend yield of 6% at a rate of $200 per share.

The investor owns 150 shares, each paying a dividend of $5 for each share (200 x $6 = $1200 total). If the investor uses their $1200 in dividends to buy six more stock shares on the ex-dividend date, the price would be adjusted by $6 per share to $193 per share. By reinvesting the dividends, the investor is able to purchase 6.22 shares since dividend reinvestment programs allow investors to purchase fractions of shares.

If everything stays the same, the investor will have 156.22 shares the following year worth $31,244. They can continue reinvesting this amount accumulating more shares each time a dividend is declared. This compounds gains similar to a saving account.

Disadvantages of Dividend Yields

High dividend yields are definitely attractive; however, they may be at the expense of a company’s potential growth. It’s safe to assume that every dollar of dividends a company pays to shareholders is a dollar it’s not reinvesting for growth and generating additional capital gains. Even if shareholders aren’t earning dividends, there is a potential for them to receive higher returns if a company’s stock value increases while they’re holding it due to company growth.

Evaluating a stock solely on its dividend yield isn’t recommended. Dividend information may be based on erroneous information or be outdated. Many companies will have a higher dividend yield while their stock value is decreasing. If there is a significant enough of a decline in the stock price, the company might decrease its dividend amount or completely eliminate it.

Investors need to be cautious when evaluating companies looking distressed and having higher-than-average dividend yields. Since a stock’s price acts as the denominator in a dividend yield equation, a significant downtrend may increase a calculation’s quotient dramatically.

How to Invest in Dividend Stocks

Building an investment portfolio of dividend stocks isn’t easy; however, for many investors, it’s worth the time and effort. Follow these simple steps when buying dividend stock:

Find a Dividend-Paying Stock

Investors can use many financial sites, along with their online broker’s site, to find dividend-paying stocks.

Evaluate the Stock

When evaluating a dividend-paying stock, investors need to compare its dividend yield against their peers’. If its dividend yield is significantly higher than other companies, it may be a red flag. If nothing else, it’s worth doing additional research on the other company, along with the safety of its dividend.

Investors should then research the payout ratio of the stock. This tells them how much of the company’s profits go towards annual, quarterly, or monthly dividends. If a payout ratio is too high, typically 80% or more, it indicates the company is paying a significant amount of its income in dividends. Dividend payout ratios may top 100% in some cases, showing a company might be going into debt due to paying out dividends.

Decide How Much Stock You Want To Purchase

Investors need to diversify when purchasing individual stocks. This means they need to decide what percentage of their portfolio goes into each security. For instance, if an investor purchases 25 stocks, they could put 4% of their portfolio in each. If a stock is riskier, though, they may want to purchase less of it, putting more of their money towards safer stocks.

The safety of a stock’s dividend is the number one consideration when purchasing a dividend stock. Dividend yields of more than 4% need to be scrutinized carefully. Dividend stocks with yields of 10% or more are definitely risky territory.

A dividend yield that’s too-high may indicate investors are selling their stock or an unsustainable payout, each of which can drive down the share price and, as a result, increase the dividend yield.

It’s Not All About Yield

A stock with a high dividend yield doesn’t necessarily make it a good investment. There are several other factors to consider before purchasing any dividend-paying stock, including:

Dividend Growth

Determine if the company has a solid history of growing earnings and rewarding shareholders with consistent dividend increases. A good point to start is the Dividend Aristocrats. They are a collection of S&P 500 stocks that have had dividend increases for a minimum of 25 consecutive years. However, keep in mind that this is not meant as financial advice, and we are not recommending any particular stocks.

Financial Strength

Determine if a company has a reasonable debt load based on its investment-grade credit rating and industry. Does it have enough working capital and cash to ride out an industry downturn or any unexpected economy changes?

Dividend Stability

Does the company have a safety margin between how much it pays out in dividends and how much it earns? The payout ratio — the percentage of profits a company spends on dividends — is a useful way of measuring this.

The payout ratio is best utilized over an extended time period, more than a single quarter or year. Investors can also augment the payout ratio with the cash payout ratio since several non-cash expenses may affect the company’s net income going by generally accepted accounting principals (GAAP).

Competitive Advantages

Determine how a company consistently beats the competition or at least keeps it at bay. A brand people are willing to pay a premium for, cost advantages, and network effects are a couple of examples of durable competitive advantages.

Growth Prospects

Determine if the company is in an industry that’s quickly growing or if it’s seeing the demand for its services and products shrinking. Even top companies in a declining industry find it difficult over time to maintain or grow its dividend.

While dividend stocks are an attractive investment option for investors looking to generate regular income from their portfolio, there are advantages and disadvantages that are important to consider.