Who doesn't want more income out of their investments? That's particularly true in a low-interest-rate environment.
With retirement easily lasting thirty years, those in or near their golden years need to generate a lot of income. To get it, many turn to high-yield dividends. But not all are created equal. There are the high-yield dividend stocks that can support their payout, and there are those that look good at a glance but aren't worth the investment. To choose the right ones, make sure you understand these four facts about high-yield dividend stocks.
1. Depending on them is risky
Dividends scream stability, but buying into that logic can set you up for disaster when it comes to high-yielding dividend stocks. The reason most companies pay a dividend is that they have more cash than they need. They have exited the high growth stage and are steadily chugging along. They reward their investors with cash payments each quarter or annually.
That approach is often applied to all dividends, including high-yielding ones. But what many fail to realize is that the dividend can get cut on the spot. Unlike interest, investors aren't locked in, receiving a fixed payment each quarter. If the business falls on hard times or the company decides it needs cash, it can reduce or halt its dividend with little in the way of warning to investors. That typically weighs on the stock. The investor is left with an investment that has declined and a lower dividend payment, if any at all.
Investors in high-yield dividend stocks have to apply a dose of skepticism to yield and look at more than just the payout. Is the company growing? Does it have enough cash to support its dividend now and into the future? How is it managing expenses? These are all things to consider.
2. Payout ratio matters more
Investors screening for dividend-paying stocks tend to look at the yield alone. If it's high enough, they assume the company is doing well. That may be true today, but what about in the future?
A better way to gauge a company's ability to maintain and increase its dividend is to look at the payout ratio. That's the portion of earnings that goes to paying the dividend. If a company's payout ratio is 35%, it means for every dollar it makes, 35% goes to shareholders in the form of a dividend. If a company has a very high payout ratio, that could signal it's in trouble and should be a red flag for investors even if the dividend yield is high.
3. Steady wins the race
Stability is what every investor wants, and it can be found in certain high-yield dividend stocks. To ascertain the stability of the dividend payments, focus on the company's track record. Did it continue to maintain its dividend even during downturns, or did it slash it as it struggled? The companies that are able to maintain and even increase their dividends during tough economic times are the ones that plan, setting aside enough cash to manage volatility. Companies that have consistently paid a quarterly dividend through the years or raised it should be the ones you focus on.
4. Beware of the dividend yield trap
Investors who only focus on the dividend yield can easily be lulled into a fake sense of security. After all, if the yield is rising, why wouldn't you want to own the stock? But a rising dividend yield isn't always positive. It can also happen if the stock price declines but the dividend remains constant. This is known as a dividend yield trap, and will push up the yield. Investors who look at yield alone could end up with a stock that won't be able to support the dividend over the long run, which will eventually send shares lower.
High-yield dividend stocks are not for the faint of heart, but they also shouldn't be ignored. Thinking critically about the company's fundamentals and looking beyond the yield will increase the odds you're choosing a stock that can continue to pay out double-digit percentages for the years to come.