How to use the dividend yield to find the best dividend stocks
I’m sharing an easy explanation to the question, “What is Dividend Yield?” using Apple dividends and some of the biggest risks to dividend stock investing.
I’ll not only show you how to calculate the dividend yield quickly but reveal my favorite dividend stock strategies for higher returns without the risk.
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What is Dividend Yield?
Probably no other measure in dividend investing is as popular or dangerous as the dividend yield. It makes sense, right? That’s your cash return and investors are all about getting as high a return as possible.
In this video though, I’ll explain the dividend yield, how to calculate it and some risks around it. We’ll talk about what is a good dividend yield and then I’ll reveal five dividend investing strategies you can use for solid returns.
This is hugely important not just for dividend investors but for all stock investors. I’ve gotten a lot of questions about our 2019 dividend stock portfolio, why I only filtered for stocks paying a 3% yield or higher instead of going for the really high yielding stocks. You only need to look at that 24% total return in just the first four months to see that it’s all about balance to getting the highest total return. Five of our dividend stocks are up over 35% so far with Hanesbrands surging 67%.
A stocks dividend yield is the cash return you get on the investment on a yearly basis. Now that’s important because most stocks pay their dividend four times a year but only pay a fourth of that annual yield. So you might see a 3% dividend yield and receive a dividend every three months but you’re only collecting that portion of the annual yield.
Using the Apple Dividend Yield as Example
Let’s look at an example with the Apple dividend because it gets much easier when you see it applied. We see here that besides having a VERY good day after reporting first quarter earnings, Apple is trading at $214 per share. This forward dividend and yield reported here is for the entire year’s payments, so investors should expect to receive $2.92 in dividends for every share of Apple they own.
What you will actually receive is $0.73 every three months but remember we use the annual number to calculate the dividend yield.
So if we take that $2.92 in dividends received over a year and divide by the current $214.16 share price, we get a dividend yield of 1.36%. It says 1.54% here as the yield and that’s an important point you want to remember. This 1.54% yield is based on the stock price yesterday so it hasn’t updated on today’s big move. Understand that as a stock’s price increases, if the company doesn’t also increase the dividend payment then the dividend yield will go down.
Conversely if a stock’s price falls and the dividend payment stays the same, the dividend yield will go up. If Apple shares were to fall to $175 each and the dividend stayed at $2.92 a year, then investors would be getting a 1.66% yield.
Risks in Dividend Yield Stocks
This uncovers one of the biggest risks in looking at just the dividend yield. If you see a high dividend yield, you also need to look at the stock price over the last year. If the shares have been falling and the dividend hasn’t been cut, that’s going to increase the yield but it could be a dangerous assumption.
First, if the company is in too much trouble, it might cut that dividend to conserve cash. Just as importantly though, what good is it to collect that hefty dividend if you lose double that on the stock price?
So dividend yield is important but it’s not the only thing you should be looking at. That’s going to be big in the five dividend investing strategies we’ll talk about now.
What is a Good Dividend Yield?
Now a good dividend yield is what you can get while still getting some upside return on the stock price. We talked about this idea in our dividend payout ratio video. A company can return all its cash to investors through a dividend but there’ll be no money left for growth and it may even lose competitive share, causing the stock to fall.
That means, when I’m looking at dividend yield and the payout ratio, I’m looking for companies with a commitment to return cash but also to grow the company.
That generally means a good dividend yield between 3% to 6% for regular stock companies. Since the dividend yield on the market, the S&P 500 is just under 2%, companies in this three to six percent range are well above the average and demonstrate that yield commitment.
Now I know that a lot of investors want to go for the highest dividend they can get, investing in stocks with double-digit yields and if the stock price doesn’t fall then that’s not a bad return. A lot of times though, weakness on the share price and volatility just isn’t worth that marginally higher dividend.
Best Dividend Yield Strategies
Let’s look at those three dividend investing strategies though because a few of them will really help you get those higher yields with some solid price returns as well.
Investing in Monthly Dividend Stocks
One of the most popular dividend strategies is investing in monthly payers. We’ve seen that most dividend stocks pay out just four times a year. That can make it difficult to plan for paying expenses if you’re living off your dividends or just as a passive income stream.
That’s where monthly dividend stocks come in, companies with a policy and a history of returning cash to investors every single month. Even better, these stocks have a median yield over 8% annually, that’s over four-times the dividend yield of the broader market.
These are some great opportunities to create that monthly cash flow that’s either going to grow your portfolio or give you that extra cash each month to pay the bills.
Now I am going to warn you, these monthly payers tend to be in just a few business types. We see here that about 40% of monthly payers are real estate investment trusts, another 38% are business development companies and then some energy companies, usually master limited partnerships. We also see the average dividend yield in each group so 7.4% on MLPs, 7.5% on REITs in the space and a whopping 10.1% average yield on BDCs.
There’s a reason for this we’ll talk about and why these cannot be your only investment in dividend stocks. Again, do not think you can put together a portfolio of just these monthly dividend stocks because it’s going to put your money at risk.
We see in that graphic, putting all your money here is going to grossly expose you to just a few business structures. These companies set up as BDCs, REITs or MLPs get special tax breaks but have to pay out almost all their earnings as dividends. That means they tend to have volatile share prices, they have to raise money regularly through debt or equity and they are highly exposed to rising interest rates.
These monthly payers also tend to be much smaller companies than other stocks. For example, of the 28 legit monthly payers I follow, the average size is just $723 million with the largest only a $20 billion company. That might seem like a lot but it’s miniscule next to a trillion dollar company like Amazon or Apple and none of the S&P 500 companies pay monthly dividends.
The fact that they are smaller companies with less financial flexibility means you need to stay up on all the usual warning signs for dividend stocks. These include sales growth, debt leverage and some other signs you need to watch.
You also need to understand the management structure in those business development companies, the BDCs. It’s either going to be external or internal management which is going to make a big difference on their compensation. External management is usually compensated by growth in the company’s invested assets, so they want to make as many investments as possible even if they aren’t necessarily great investments. Internal management compensation is tied more directly with investor returns.
Finding these monthly dividend stocks is pretty easy with any stock screener or a Google search on monthly payers. What I want you to consider when you’re using this strategy are just a couple of points.
First is to make sure you spread your dividend portfolio across different sectors and business types. That probably means only having a chunk of your dividend investments in these monthly payers since they’re mostly those REITs, MLPs and Business Development Corporations. Second is to pay attention to the share price over the last few years as well. Don’t get caught up in that high dividend yield because you don’t want it at the expense of a falling stock price.
Investing in Dividend Aristograts
One dividend strategy we haven’t talked about on the channel but actually has a lot of research to support it is the Dividend Aristocrats.
Dividend Aristocrats is the name given to companies in the S&P 500 index, so we’re talking companies of about $5 billion or larger, that have increased their dividend payment for at least 25 consecutive years.
Nearly three decades of increasing dividends is a huge commitment, especially considering that includes the 2008 recession which was the worst in 80 years. Stocks that increase their dividends have been shown to outperform the rest of the market and these Aristocrats are a great way to play on that.
That list peaked at 64 stocks in 2001 but has since fallen to just 57 companies that meet the filter. Over the decade to March 2019, the Aristocrats have returned an annual 17.6% versus a 15.9% return on the broader S&P 500 market index. Not only has it outperformed the market but the Aristocrats index has also done it with less volatility, so fewer violent ups-and-downs in the prices.
Now instead of trying to keep track of all 57 companies in the Dividend Aristocrats list, there are funds like the Proshares ETF, ticker NOBL, that will do it for you. The fund holds all stocks in the Aristocrats index and has a 2.3% dividend yield. What I want you to notice though if you’re going to invest in the fund or the Aristocrats stocks, is this fund sectors and their weighting. Most of the fund is in just a few sectors like consumer staples, industrials and financials.
That’s obviously a function of how safe the sectors are for cash flow and how the companies have been able to keep increasing their dividends year-over-year but you might want to pair this fund with another that has maybe a growth stock perspective. The reason here is that way you get more from sectors like tech, consumer discretionary and others to balance out the heavy weighting in just these three sectors in the Aristocrats fund.
Investing in High Yield Stocks
Another strategy, actually my favorite dividend yield strategy, is investing in real estate investment trusts, REITs, and master limited partnerships, MLPs.
Like we saw in that previous strategy, these are special types of companies that get tax breaks for returning most of their cash flow to investors. Not all of them are monthly payers though and I think some of the best picks are actually those normal quarterly-paying stocks.
So REITs or real estate investment trusts, are companies that own and manage property, usually commercial real estate property. The company pays expenses then passes through at least 90% of the earnings to investors in the form of dividends. Investing in REITs, it’s important to spread your investment across companies with different property types like office, warehouse, hotel, data centers, retail, industrial and self-storage.
MLPs or master limited partnerships own mostly pipelines that transport oil and natural gas and then the storage facilities. They collect a fee from other energy companies for using the assets and pass most of their earnings on to investors. Since much of their fee is based on the amount that goes through those pipelines or is stored in tanks, they aren’t quite as depending on energy prices so it can be a great way to lower the risk of weak oil or gas pricing in your investments.
With REITs and MLPs, I want to cover two very important points to help you when you’re looking for these stocks. First is that taxes on the investments are handled very differently.
Taxes on dividends from REITs are like any other dividend stock. If you hold the shares for more than 60 days around that dividend payment, you pay a lower qualified dividend tax rate and you pay those taxes each year on the dividends you collect. One of the best pieces of advice I can offer with dividend investing is to hold these high-yield stocks in a retirement account, either an IRA or a Roth IRA. That’s going to save you from having to pay those taxes each year on the dividends and will seriously boost your returns.
MLPs, master limited partnerships, are taxed entirely differently. For each MLP company you own, you’ll get a special tax form each year called a K-1 form. This is going to break out the dividend between a return of capital and a normal dividend portion. Now that return of capital portion of the dividend, and this usually ends up being the majority of the dividend, isn’t taxed each year. It actually goes to lowering the taxable price you paid for the shares so you don’t get taxed on it until you sell your shares.
It’s a huge tax break, shielding you from that annual tax hit on the full dividend but it also means you don’t want to hold these in a retirement account. Hold these MLP investments in a regular taxable investing account so you take advantage of that tax-deferred benefit.
The second point I want to cover for REITs and MLPs, and this is the biggest mistake I see investors make on the two investments, is that you can’t use a lot of traditional value measures.
These companies own assets like real estate and pipelines that mean a huge amount of depreciation on the income statement. They take that depreciation off their earnings to lower taxes but it also means that earnings are a terrible view of profitability for the business.
So if you ever hear anyone talking about the price-to-earnings ratio of an MLP or a REIT, they don’t know what they’re talking about. You can’t use the P/E ratio with these stocks. There is a special way to value each of these types of stocks and I’ll show you how to do that for each.
What we’re going to use for MLP stocks is use what’s called price-to-distributable cash flow or price-to-DCF. Finding this value for distributable cash flow, the amount of money the company has available to return to investors, is important also because it gives us an idea of sustainability. A company can’t pay out more than is available forever so it’s a good metric to make sure that dividend isn’t going to be cut any time soon.
I’ll show you how to calculate DCF yourself but all MLPs will calculate it on their reporting. I do it myself only because I like to double-check the numbers coming out of the company and make sure I’m comparing stocks with the same calculation.
Here’s the table, and again don’t get freaked out because this is always provided to you in reporting. To find how much money the company has available to distribute, you take the cash flow from operations, this is all going to be found on the Statement of Cash Flows, and you remove any spending on capital and income from non-controlling interests. That gives you sustainable DCF which is what the company can return to investors and still keep operations running smoothly.
While sustainable DCF is a better measure, most people use the DCF as reported because it’s sometimes the only number reported. To get to DCF, you also add back that income from non-controlling interests as well as working capital reported. The big one here is adding back this proceeds from asset sales. This is technically proceeds the company can return to investors, a company can’t forever be selling its assets and still keep business running so that’s why we use that sustainable DCF if it’s available.
With this number, you can find that valuation with the price-to-DCF or you can find how much the company is returning to investors for what’s called the distribution coverage ratio. This is how much DCF the company earns versus how much it pays out.
Just like with MLPs, you can’t rely on reported earnings for a REIT because of that high amount of depreciation they get from real estate. Instead, we use a measure called Funds from Operations or FFO.
FFO is very similar to that DCF we saw with MLPs. You take the reported net income of the REIT and add back depreciation but minus out any gains they made on property sales. Those property sales are a source of income but not something the REIT can do forever and expect to stay in business. Remember, the idea is to find how much cash the company has available to distribute without cutting into money it needs to run the business.
Again, like the DCF calculation for MLPs, you don’t necessarily have to do this yourself because it’s always reported by the company. It’s just a good idea to understand the concept and be able to double-check the company’s reporting.
You use FFO just like our other metric so you can take the price of the REIT over FFO to compare the valuation to other REITs. You can also get a coverage ratio of FFO over the dividend to see how safe the yield is for the stock.
We’re about half way through out 2019 Dividend Stock Challenge portfolio and the stocks are blowing up. The portfolio is up over 24% so far and beating the market by nearly ten percent. Make sure you click through to this video and check out the portfolio and how I use dividend yield to build a solid investment plan.