Topic: Dividend Stocks

Understanding dividend yield is a key part of finding stocks for a profitable long-term portfolio

December 6, 2022|by Scott Clayton

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Understanding dividend yield and divided sustainability will help you invest in stocks that will give you steady income as well as growth prospects

Understanding dividend yield is an important part of planning and building a sound portfolio. Dividend yield is calculated as the total annual dividends paid per share, divided by the current stock price. Movements in the stock price will change the dividend yield.

When you’re looking for income-producing stocks, dividend yield is typically your most important consideration. The best companies to invest in for a high dividend yield have strong positions in healthy industries. They also incorporate strong management that makes the right moves to remain competitive in changing marketplaces.

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Understanding dividend yield that is misleading

A high yield, of 3% or 4% or more, is usually taken to represent good value.

But an exceptionally high yield (closer to 10%, or higher) is often the result of a falling share price and may actually signal that the dividend itself is in danger of being reduced, if not cut altogether.

Dividend yield is one very useful factor in judging a stock’s value, but only one. It is best used in combination with other indicators or tools.

Understanding dividend yield and the payout ratio

One of the best ways to judge whether a company will keep paying its dividend, or even increase it, is the dividend payout ratio. This simply measures what portion of a company’s earnings are allotted to paying dividends.

If a company keeps its payout ratio fairly steady, say at 7% of earnings, and its earnings grow, the amount you receive in dividends should also grow. However, if a company must keep paying out a larger and larger percentage of its earnings just to maintain the dividend, it is reasonable to wonder whether the company is in decline and the dividend is in danger of being cut.

You need to look at other factors, as well, of course. The company may be going through a low cycle in its industry, or have a temporary problem it has a good chance of solving.

Understanding dividend yield, dividend cuts, and stability

Dividend cuts will always undermine investor confidence and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks with high dividends that has been maintained or raised during economic or stock-market downturns. Generally, these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.

A track record of dividend payments is a strong sign of reliability and an indication that investing in the stock will be profitable for you in the future.

Understanding dividend yield and lowering your tax bill in the process

Canadian taxpayers who hold Canadian dividend stocks get a special bonus. Their dividends can be eligible for the dividend tax credit in Canada. This dividend tax credit—which is available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will cut your effective tax rate.

This means that dividend income will be taxed at a lower rate than the same amount of interest income.

Factors to help you determine if a stock will keep paying a dividend

• Look for companies with long-term success. These companies are the most likely to keep paying and increasing their dividends.
• The current financial health of a company. If a company is doing well, has done so consistently, and shows signs of growth, these factors are indicative of stocks that will keep paying a dividend.
• A company’s current dividend. If a company currently offers a healthy dividend, this is a good sign of its potential to continue offering a steady dividend.
• Note the competition. Look for companies with a strong hold on a growing market and a unique product or service that cuts its competition.

Keep these two key points in mind while looking for top dividend stocks:

• Dividends can grow. Stock prices rise and fall. That means capital losses often follow capital gains, at least temporarily. Interest on a bond or GIC holds steady, at best. But the best dividend stocks like to ratchet their dividends upward—hold them steady in a bad year and raise them in a good one. That gives you a hedge against inflation.
• Dividends are a sign of investment quality. Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So, if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

For a true measure of stability, focus on companies that have maintained or raised their dividends during recessions and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

Use our three-part Successful Investor approach to find top dividend stocks

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What traits do you look for beyond dividend yield when buying a stock?