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Why Invest in High-Yield Dividend Stocks?

Investing in high-quality dividend stocks is a proven way for investors to grow their wealth. Although often thought of as the domain of retirees and other risk-averse investors, dividend stocks...

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This story originally appeared on MarketBeat

Like many decisions that pertain to stocks, the fundamentals matter

One of the metrics used to measure a company’s dividend is known as its dividend yield. If a company pays a dividend, the yield is found on nearly every stock quote page. The dividend yield is a calculation of a company’s announced dividend per share divided by its current stock price.

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In general, the higher the yield, the more attractive the company is as an investment choice. However, investors still need to look at a company’s fundamentals before investing in a high-yield dividend stock. That’s because, dividend yields and share price move in opposite directions. This means that a dividend yield could be moving up even as a company’s share price is going down.

In many cases, that is nothing for investors to get too concerned about. Dividend-paying stocks tend to be in defensive industries that are consistent performers in any economy. However, investors should pay close attention to see if there are other reasons to be concerned about the company’s fundamentals. Some financially troubled companies will issue a high dividend in order to attract investors.

In this article, we’ll help investors understand when a high-yield dividend stock offers real safety and when they should be avoided. We’ll also give you some sectors that are the best for finding quality high-yield dividend stocks.

What Are High-Yield Dividend Stocks?

Before we answer that, we’re providing a quick overview of what investors mean by dividend yield. A company’s dividend yield is a measure of how much money per share a company pays out as a dividend. The yield is 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 $5 dividend per share will have a dividend yield of 5%.

5/100 = .05 (5%)

High-yield dividend stocks are those stocks that pay the highest dividend in terms of yield. While there is no particular percentage that constitutes a stock as having a high dividend yield, you can compare it to stocks in its sector that have a similar market cap. In some cases, a dividend yield of around 4% is considered a high yield. However, there are some sectors where a 2-3% dividend is considered an exceptional yield.

Why is a High-Yield Dividend Significant?

Despite not being a 100% accurate predictor of a company’s overall financial position, a high dividend yield is generally considered to be a sign of financial strength. Companies that issue dividends will typically go to great lengths to preserve, and even, increase their dividend. The best of the best have names such as dividend princes, dividend aristocrats and dividend kings. These designations mean that a company has increased their dividend per share (not the yield) for 10, 25, or 50 years respectively.

What are the Characteristics of High-Yield Dividend Stocks?

They are at a mature phase of their business cycle - Young companies that are seeking growth will reinvest their profits back into their business. This will allow their share price to rise and allow shareholders to get the benefit of capital growth. As a company matures, its opportunity for growth through reinvestment may get smaller. When this happens, they may decide to reward their shareholders by paying a dividend.

They are in defensive industries - Dividend-paying companies share the characteristic of being in defensive industries. A defensive industry is one that holds up in any economy. During bull markets, these stocks will not show the highest growth but during bear markets, they will hold their share price better. It’s the difference between riding a roller coaster or a carousel. Growth stocks can be a thrill ride, but investors have to stomach a lot of turbulence to lock in gains. Riding a carousel may move you up and down but have less volatility.

Two special kinds of dividend stocks that investors should look into are real estate investment trusts (REITs) and business development companies (BDCs). Both types of companies are required to pay out at least 90% of their taxable income as dividends. Many of these companies will pay their dividends monthly rather than quarterly which can provide an additional benefit for fixed income investors.

How Dividend Reinvestment Plans Make High-Yield Dividend Stocks Attractive

Income investors who are in their retirement years may want, and/or need, the steady income that regular dividend checks provide. However, for investors with a longer time horizon, a dividend reinvestment plan (or DRIP) may be the way to make high-yield dividend stocks even more attractive. With a DRIP, the regular dividend payment an investor receives goes into purchasing more shares of the company stock.

For example, Duke Energy Corporation (NYSE:DUK) pays a dividend of right around 4%. Their share price is currently around $90. If an investor held 500 shares, their investment in DUK would be $45,000. When it came time for a dividend to be issued, they would receive 1% every quarter (the dividend yield always reflects an annual total dividend – in this case 4% annually) of the total value of their holdings. In this case, one percent would be $450. By reinvesting that money they would own an additional five shares of DUK. By the end of the year, if the stock price and dividend remained the same, the shareholder would own an additional twenty shares of the company stock.

But that only tells part of the story. As the dividend gets reinvested the total investment increases. Even if DUK’s stock stays at $90 exactly, when the next quarter comes around, the dividend would be calculated off of $45,450. This would add an additional $4 to the dividend. And the investor may receive even more if the company has a history of increasing their dividend. 

Of course, the share price is affected by market conditions. If you reinvest your dividends in a company and the stock goes down, you will be buying more shares. If the share price goes up, you will be buying fewer shares. Still, a company’s dividend announcement is usually independent of its share price and reflects a company’s overall financial health.

When is a Dividend Yield a Trap for Investors to Avoid?

Dividend yields are not as significant to investors as the amount of the actual dividend per share. This is because share prices and dividend yields can have an inverse relationship.

For example, a stock that trades at $80 per share with a $4 per share dividend has a 5% dividend yield. If that stock suddenly shoots up to $85 per share but keeps its dividend at 4%, the dividend yield will decline (in this case to 4.7%).

In this case, an investor could look at the lower yield and think the company has reduced the dividend when, in fact, they will receive the same dividend. The difference is they will also have realized capital growth. This is one of the benefits of dividend stocks in general, the ability to have income and growth.

The opposite is also true. If the company saw its share price go down to $75 per share, but kept the $4 per share dividend, the yield will increase. Does this mean that investors would get more? No. In both cases an investor that owned 100 shares of stock would receive a $400 annual dividend ($100 paid per quarter).

The takeaway from this is that investors should not chase a high yield and instead look at the company’s track record. A high-yield dividend is only significant if the company is able to consistently pay the dividend at its current payout amount or, ideally, higher.

The Final Word on Investing in High-Yield Dividend Stocks

Investing in high-quality dividend stocks is a proven way for investors to grow their wealth. Although often thought of as the domain of retirees and other risk-averse investors, dividend stocks are actually a solid choice for investors of all styles. The reason dividend stocks merit a close look is that they offer investors a two-pronged benefit of regular, predictable income and the opportunity for capital growth.

Even though there is an allure to dividend stocks, there are many investment advisors that would say income-oriented investors should look at bonds because they will pay a fixed interest rate that is not subject to the whims of the market. That may have been true in the past. However, since the onset of the financial crisis in 2007, U.S. treasury yields have been at historic lows. This has added to the appeal of dividend stocks which pay a higher yield than what investors can get by investing in U.S. government debt. An added benefit to owning dividend stocks is their ability to generate additional capital growth through share price appreciation.

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