On its face, a high yield of a dividend stock can be extremely attractive to any investor looking to add a stream of income to their portfolio. Imagine bolstering your portfolio by buying stocks with a dividend yield of 5%, 10%, or even 15%. Investors could cruise into their retirement, confident that they could realize a steady stream of income, feeding their financial well-being.
However, high yields on dividend stocks can become good to be true, especially for those investors who use this as their primary bellwether for selecting stocks. Don’t go chasing the high yield of a dividend stock. Instead, there is a simple formula for income investors that will prove to be more successful and potentially make you much greater returns, both in asset growth and income.
A dividend yield is calculated by dividing the Dividend per Share/the Current Share Price. For example, if you bought a stock that had a $5 Dividend Per Share and the price of one share was $50, the dividend yield would be 10% ($5/$50 = 10%).
Again, at first glance, any investor would be happy to take a 10% dividend yield and let that income flow freely into their account while they enjoyed the white sand beaches of Capistrano. Though, often things are not quite as they seem and income investors chasing the dividend yield can easily get burned if they are not other factors into consideration.
If that 10% historical dividend yield is the only factor an investor looks at when deciding to buy a stock, they could be setting themselves up for a disaster. For instance, let’s say this $50 share price was an oil or energy stock that was purchased at the end of 2019. There is a good chance that this stock is at least half of its value since oil and energy took a beating in 2020.
Chances are, if the share price of this stock was cut in half, the company most likely cut their dividend per share as well. So, now instead of a 10% yield at $5/$50, you have a 10% yield at $2.50/$25. This is obviously not the direction you want to be headed if you are depending on this income in your portfolio and a classic example of how a high dividend yield can be deceiving at best and catastrophic at worst if you are overloaded in this stock.
Conversely, a dividend yield will tend to go down if a share price goes up. If that $50 stock were bought in early 2020 and was a tech stock, that share price could have gone up. If that dividend per share stayed at $5 but the stock went up to $60, then dividend yield would have gone down to 8.3%. Again, investors chasing that high-yield above 10%, may miss out on a healthy trending stock and the chance for a better income flow.
There are two major factors investors should consider before looking at dividend yield.
When you consider these two factors, the dividend yield almost becomes arbitrary. In fact, even if the dividend yield shrinks, it could be because the share price is outpacing a growing dividend. If this is the case, I would throw dividend yield out the window and take a close look at purchasing that stock because you are looking a some quality indicators.