One of the most metrics used to describe a company’s dividend is its dividend yield. The dividend yield is a calculation of a company’s announced dividend per share divided by its current stock price. In general, the higher the yield, the more attractive the company is as an investment choice.
In this article, we’ll explain the significance of high-yield dividend stocks and how they can benefit investors of all styles. And we’ll also help you identify times when a high yield is a trap that can lead you to buy shares of financially troubled companies.
What is a dividend yield?
A company’s dividend yield is a measure of how much money per share a company pays out as a dividend expressed as a percentage. The formula for dividend yield is:
Annual dividend per share/price per share
For example, a company with a share price of $100 that pays a $3 annual dividend per share will have a dividend yield of 3%.
3/100 = .03 (3%)
What are high-yield dividend stocks?
An accepted definition of a high-yield dividend stocks is one that has a dividend yield above 4%. However, it’s important to compare a stock with others in its sector. For example, a dividend of 2.5% in some sectors is exceptional. In others, a 4% yield is low. Therefore an apt description for investors is that a high-yield dividend stock is a stock with an above-average yield for its sector.
Why Invest in High-Yield Dividend Stocks?
Investing in high-yield dividend stocks is a proven way for investors to grow their wealth. Dividend stocks offer investors a two-pronged benefit of regular, predictable income and the opportunity for capital growth.
In fact, since the financial crisis of 2007, U.S. treasury yields have been at historic lows. This means that many high-yield dividend stocks offer a higher yield than that of U.S. government debt. Plus, investors who reinvest dividend stocks have an ability to generate additional capital growth through share price appreciation.
What is a Dividend Reinvestment Plan (DRIP)?
Many investors buy high-yield dividend stocks to get a regular supplement to their income. That’s why dividend stocks are often thought of in connection to retirees and others living on a fixed income. However, investors who don’t need the money right away can benefit from re-investing their dividends.
Many dividend-paying companies have a dividend reinvestment plan (DRIP).By reinvesting dividends, the regular dividend payment goes into buying more shares of that company’s stock. Over time this strategy has been proven to increase an investor’s total return.
For example, let’s say Simon Property Group (NYSE:SPG) has a dividend yield of approximately 7%, a payout ratio of $6.80, and a share price of around $95. If an investor owns 500 shares on the ex-dividend date, they would receive 25% of the $6.80 or $1.70 per share. That calculates to $850 that would be available to reinvest in SPG stock. And that means that he investor would have purchased almost nine additional shares of the company’s stock.
This is where compounding kicks in. For this example let’s assume the investor holds onto their shares and does not buy additional shares. Furthermore let’s assume there is no change to the SPG stock price and/or dividend payout. In the next quarter, the investor will receive $1.70 per share for 509 shares.
Over time, this reinvestment strategy has a snowball effect where the investor receives additional shares without putting out any of their own capital. Furthermore, if the company increases their dividend, the payout will be even larger.
Do High-Yield Dividend Stocks Restrict Growth?
Yes and no. Many of these companies show consistent revenue and earnings growth. They may have an occasional bad quarter as any company will, but the trend is always towards growth.
That being said, investors can expect that these companies may have less growth than a growth stock that doesn’t pay a dividend. The key with high-yield dividend stocks is consistency. It’s that consistency that will allow a company to sustain or even grow its dividend.
When a High Yield Tells a Different Story
As we said in the introduction, generally speaking a company with a high dividend yield is more attractive to income-oriented investors. However, investors must still perform their own due diligence.
One reason for this is that a dividend yield has an inverse relationship with a company’s stock price. When a company’s share price goes up, the yield will go down. Conversely when a share price falls, the dividend yield rises. Both statements assume that the dividend payout stays the same.
In the case where a share price is rising, investors may want to know why the company is choosing not to increase its dividend. And in the case where the stock price is falling, investors will want to study the company’s fundamentals to ensure that there will not be sustained pressure on revenue and earnings. This is known as a yield trap and it can do harm to investors who are relying on a steady stream of income.
Some Final Thoughts on High-Yield Dividend Stocks
There’s no such thing as a sure thing. And that is true of high-yield dividend stocks. Because of its inverse correlation to share price, dividend yield does not accurately predict a company’s financial position in every circumstance.
However, companies that have a high dividend yield are generally on strong financial footing. And once a company begins to issue a dividend, they will typically make maintaining and/or growing the dividend a priority.