- Investors are always on lookout for stocks that pay high dividends to boost their income.
- Investors use parameters such as dividend yield to pick up stocks that match their needs.
- However, investors should be wary of chasing high dividend stocks.
Investors are always on lookout for stocks that pay high dividends to boost their income. A dividend is a distribution of profit by a company to its shareholders. The company’s board can decide to pay a proportion of the profit in the form of dividends to shareholders. Several firms listed on ASX generally pay dividends two times a year. These dividends are known by the names – ‘interim’ and ‘final’. However, a company does not need to pay dividends two times a year.
Dividend-paying stocks are even more enticing when the economy is facing hardships, or the official interest rates are hovering around record lows.
Investors use parameters such as dividend yield to pick up stocks that match their needs. A dividend yield is a financial ratio that is used to determine how much dividend is paid by a company relative to its stock price. A high dividend yield stock should generally be an ideal bet for growth investors.
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Risks of investing in high dividend stocks
Investors should be wary of chasing high dividend stocks. For instance, a stock’s dividend yield could be on the higher side due to a significant fall in its stock price, implying a financial trouble that could impact its ability to deliver future dividends. According to experts, investors should also ask themselves the reason why stock’s dividend yield is high before going for a buy.
In the case of a company undergoing financial distress, a high dividend yield may not last long. Then, such a company is forced to suspend dividend payout in future to save cash, leading to further fall in its share price.
Suppose a company with a stock price of AU$60 pays a $3.50 annual dividend for a 6% yield. However, company’s stock price halves to AU$30 due to some shock. Now, the company appears to be paying an 8.5% dividend yield. But it could be temporary, and the company would soon reduce the dividend. Thus, investors should carefully consider company's financial health and operations and evaluate whether it can maintain its dividend payments.
Key factors to consider
Investors should consider these four factors while considering a company’s stock based on its dividend -paying capacity:
- Free cash flow
- Historical dividend payout ratio
- Dividend schedules
- Increase or decrease in payments
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Most blue-chip companies pay dividends to their shareholders. These companies have a steady record of paying dividends over the years. However, several new companies keep establishing themselves, while others struggle to maintain consistency. Thus, investors should maintain due diligence while selecting fundamentally strong dividend-paying stocks.
Interest rate risk
There could also be an interest rate risk associated with high dividend-paying stocks. A scenario of rising rates could make dividend stocks less attractive. Conversely, with a fall in interest rates, high dividend stocks become more attractive to investors.
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Similarly, a hike in rates could make dividend stocks less attractive to investors, resulting in an outflow in equities, specifically in general and dividend stocks. It happens because investors generally compare dividend yields with the risk-free rate of return a government bond could earn.
The dividend yield of 6% paid by a company in the earlier example becomes less attractive if the interest rate rises to 5%. It is because most investors will prefer the safety of the guaranteed 5% return rather than risk their principal for an extra 1% yield.
The bottom line
While high dividend-paying stocks provide a good opportunity to boost investment portfolios, investors should carefully evaluate the risks associated with them. It is important to avoid judging a company based on dividend payment alone. One should avoid the temptation of chasing names with high dividend yields and instead focus on stocks’ fundamentals.