High dividend yields are a popular target for any number of investors, from income investors who rely on those dividends to supplement or replace their income (typically in retirement) and long-term investors that are interested in leveraging the power of compounding to value investors who lean on the dividends to generate portfolio returns while they wait on the market to recognize the true value of their underappreciated investments.
It stands to reason then, that identifying stocks with a high dividend yield may be an investing shortcut to maximizing returns and finding undervalued stocks.
The truth is, finding a stock with a high dividend yield on a stock screener is only half the battle.
Just screening for the highest-yielding stock in an index or industry won’t offer much additional information about the quality of the company paying the dividend, the company’s history of dividend payments, or whether the yield is artificially inflated by one-time special dividends.
It’s also important to consider what constitutes a high dividend. After all, it’s relative. A high dividend yield for a fast-growing tech stock may be only 1.5% (Information Technology as a sector offers an average yield of about 1.1%; Real Estate yields closer to 3.7%).
Plus, some companies have disproportionately high trailing dividend yields (prior 12 months of dividends / share price) due to a decline in share prices. Often, especially with stocks that are known for their high payouts, that declining share price is an indication that the market may be losing faith in the company’s ability to sustain its dividend.
There’s a lot to consider, so, let’s start with some basics.
The Basics of Dividends
A dividend is frequently a cash distribution (although not always) from a company or fund you own.
On the fund side, ETFs and mutual funds are obligated to return distributions from the assets they invest in to shareholders.
Distributions from funds can be classified as dividends, capital gains (from sales within the fund), or returns of capital (which reduces your cost basis).
Distributions from individual stocks are normally treated as either qualified or nonqualified dividends, but if you own limited partnerships or REITs, your mileage may vary (partnerships may classify their distributions as income, rather than the categories mentioned above).
In some cases, individual stock holdings may distribute stock dividends (most often from spin-offs, mergers, or other corporate actions), but it’s not typically included when you’re calculating dividend yield.
What Is the Dividend Yield?
The dividend yield is the annualized dividend as a percentage of the share price. A $5 annual dividend on a $100 stock would give you a 5% dividend yield. Assuming the dividend didn’t change, and the stock price rocketed to $200 per share, your dividend yield is now 2.5%. On the other hand, if the stock price drops to $50 per share, your dividend yield goes up to 10%.
If you’re a long-term investor, you should also consider your “yield on cost,” which is the current dividend yield of a position based solely on your original purchase and not including the compounding effects of reinvested dividends (or price appreciation). Warren Buffett, for example, has a yield on cost for his Coca-Cola (KO) investment of about 60% because his original $1.3 billion position now pays him over $770 million each year.
So, what constitutes a high dividend yield?
There are a few ways to think about this.
One is to compare a stock’s dividend yield to the yield on the S&P 500 (historically about 1.8%). Another is to compare the yield on a stock to its sector (as we did above).
Because the risk profiles are so different (a high-flying tech stock is generally riskier than a slow-and-steady consumer staples stock), I prefer comparing the dividend yield on stocks to their sectors or, even better, their peers.
Identifying Stocks with High Dividend Yields
A stock screener (such as FinViz) is a good place to start because you can screen for something as simple as an S&P 500 company paying a dividend of 5% or more. The screener will indicate what sector (and subsector) that company is in, which can help you determine how high (or low) the payout is relative to the sector as a whole or to peer companies.
Once you’ve identified a stock with a high dividend yield relative to its peers, it’s worth digging into why. Looking at the investor presentations that frequently accompany quarterly reports is a good place to start.
Companies like to highlight “shareholder-friendly” actions like stock buybacks and dividends (often framed as returning cash to shareholders). If the company is touting its dividend payments in shareholder presentations, it’s added evidence that maintaining (and growing) the dividend payout is a priority for management.
What About Funds?
One advantage to targeting high-dividend funds is that fund managers are required to run their funds in accordance with the fund’s stated objective.
So, anything calling itself a “Dividend Fund” or a “High-Dividend Fund” will be obligated to invest most of its assets in stocks that meet the fund’s criteria at all times.
Dividend Aristocrats and the associated ETF (NOBL) are good examples, as the fund is “the only ETF focusing exclusively on the S&P 500 Dividend Aristocrats—high-quality companies that have not just paid dividends but grown them for at least 25 consecutive years.”
All dividend ETFs will have a similar description that will help investors understand the funds’ criteria for investing in different stocks. If you’re looking at a fund, that should be the first thing you look at.
On a side note, if you’re interested in individual stocks, looking at the holdings of existing funds is a good way to add ideas to your watch list. You’re letting the fund managers do all the research for you!
There’s no hard and fast rule for what constitutes a high dividend yield, but anything in the double digits is uncommon and should prompt added due diligence. That’s not to say you should assume they’re unsafe, there are Business Development Companies (BDCs) that offer that kind of yield after all, but if the company isn’t specially structured to make (and sustain) such high payouts, it’s a potential warning sign (just look at what’s happened lately with Walgreens (WBA)).
On a final note, if you’re looking for stocks with high and sustainable dividends, consider subscribing to Cabot Dividend Investor, where Chief Analyst Tom Hutchinson does all the screening for you.
