How to Avoid Danger When Searching for a Good Dividend Yield
By Sasha Cekerevac for Daily Gains Letter |
When looking at the historical returns of stocks, a recurring investment strategy that has been successful is to have some equities that have a dividend yield. Adding this type of equity to a portfolio can help boost long-term returns and smooth out the volatility.
However, a dividend yield investment strategy is not as straightforward as simply looking for stocks that have the highest dividend yield. One must carefully choose equities for a portfolio that hit a number of criteria.
A company can issue a dividend, but they are not forced to continue making payments, unlike a bond. A bond is a contract in which an investor owns a company’s debt, and the firm that borrows the money must pay according to the covenants of the bond issuance. Dividend yield is the return on payments made by the company to shareholders, effectively returning capital to the owners.
When looking for stocks for this investment strategy, one must pay attention to the financial strength of a corporation. The stronger the company, the more likely it will continue issuing a dividend. If a company has a weak balance sheet, there is the potential that the firm may cut or eliminate its dividend yield altogether.
One way to evaluate companies for this investment strategy is to look at the free cash flow payout ratio. The payout ratio is the percent of cash that the firm is issuing to maintain its dividend yield. If a company is paying out most or all of its cash in the form of a dividend yield, this is a warning sign, as the firm might not be able to continue doing this forever.
As always, when forming an investment strategy, diversification is extremely important. Just because a company has been around for decades and has maintained a strong dividend yield, one should never place all their eggs in one basket. Having a variety of stocks in different sectors will help spread the risk profile of the overall portfolio.
While adding dividend yield to a portfolio is a good long-term investment strategy, watching out for some of these pitfalls will help prevent costly mistakes. Companies that have a history of issuing a stable dividend yield with the potential to increase it over time should be on the top of one’s watch list as part of an overall investment strategy.