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As investors reach for yields within a low-rate environment, companies with high dividend yields may look attractive. However, though a stock may offer a high dividend yield, you should always “look under the hood” before buying.

Stocks that pay steady dividends can be shrewd investments, especially if you hold them for a long period of time. When you add the dividend alongside any capital gains, you enjoy both a steady income and capital growth.

One popular way investors look for high dividend paying companies is by looking at the dividend yield of their stock. A stock’s dividend yield tells you what percentage the stock returns relative to its price.

How to Calculate the Dividend Yield

Analyzing a stock’s dividend yield reveals how much of an additional cash benefit you’re receiving by investing in a particular stock.

For example, if a stock trades at $50 and the company’s annual dividend is $2.20, the dividend yield is 4.40%, or $2.20 divided by $50.

Dividend Yield = annual dividend per share / current stock price

While it may seem straightforward to simply buy the stocks of companies that have a dividend yield over a certain amount (e.x. over 3%), you should not make investment decisions based solely on this one criteria. If things were that simple – we would all be rich by now.

Look Out for the Dividend Yield Trap

If you are not careful in your analysis, a dividend yield can lead you into a trap. The divisor of the dividend yield calculation is the stock’s current price per share. If the price drops and the dividend remains the same, the dividend yield will increase.

The “trap” comes into the mix, when you buy the shares of a company because they offer a high dividend yield, but in actuality, the company is an underperformer within its industry, or may even be on the verge of bankruptcy. As a result, if a company finds itself in a situation such as this, there is a good chance that the company may not be able to afford to pay its dividend. This would result in the company having to cut its dividend payments, or even scrap them all together.

Therefore, when searching for a dividend paying stock for additional income, you must always consider what the prospective company’s other fundamentals look like. A company’s dividends are paid out from its cash, and that cash comes from its earnings. You must ask questions such as “Does the company have a healthy cash flow?”, “Does the company have a consistent history of earnings and strong earnings growth?”, “Is the company underperforming or overperforming against its peers?”, “Does the company have a lot of debt and interest payments to make, that could siphon cash away from its dividend payments?” etc. It is questions such as these, that a shrewd investor should ask themselves when searching for dividend candidates.

Dividend yield is just one of the many investment criteria that you can examine through financial websites, such as www.finviz.com and www.tradingview.com, to screen for possible investment candidates.

You want to make sure that you set the stock screen to select companies with a strong history of earnings and earnings growth, strong earnings growth into the future, and a strong dividend history. If a company meets all of these key metrics, you just may very well have a possible investment candidate to invest into.

Conclusion

Companies with a high dividend yield may be fantastic investments, if the rest of their fundamentals are strong. When searching for dividend stocks, you must be careful when only one criteria looks good, but the rest are questionable at best. That’s a red flag that something is not right with the company.

It is also important to look at annualized return for the stock over a one year, five year, and 10 year period, as a high dividend yield won’t compensate for a company and stock price that is in decline.

Overall, when a dividend candidate looks too good to be true, it will always be beneficial to you to take the time to conduct your due diligence on the company. In doing so, you can avoid any dividend traps, and come out stronger and wealthier than ever before.

© 2020 Economics Global Inc.

Content Disclaimer
Any views expressed here are those of Economics Global Inc. as of the date of this publication, are based on available information, and are subject to change without notice. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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