With the stock market taking quite a tumble over the last two years, dividend yields have been rising. As such, over a fifth of the 350 largest companies on the London Stock Exchange now offer a payout of 6% or more. And with the economic situation improving, it’s possible that time is running out to make the most of this rare opportunity to lock in chunky passive income streams.
So, should investors be snapping up shares as quickly as possible? Or is there a reason to be careful? Let’s take a look.
High yields, high rewards?
Two primary factors drive the dividend yield on any stock. They are the value of dividends paid by the business and the share price. In most cases, it’s the latter that’s responsible for pushing yields up. And 2023 has been no different.
With valuations dropping, yields have been rising. In some instances, rapid sell-offs have even pushed payouts into double-digit territory. But as tempting as these income opportunities seem, investors may need to exercise restraint.
Dividends are never guaranteed. They’re funded by excess earnings from operations. High yields may be an early warning of trouble brewing should the drops in market cap be triggered by expectations of weaker performance.
What to look for?
Many FTSE companies continue to face short-term challenges. Some are more severe than others. Regardless, investors should be paying attention to whether a firm has the financial capacity to support its payouts to shareholders.
This is where the payout ratio comes into play. By comparing the total gross dividends paid versus excess earnings from operations, investors can determine how much is being consumed. Generally speaking, the smaller the number, the better, as it means there’s more wiggle room to maintain dividends even if earnings are temporarily hurt.
Another metric to watch is the level of cash on the balance sheet, as well as any upcoming maturities on debt. A cash-rich balance sheet is less likely to run into financial woes. And if the loan book has no upcoming principal repayments, pressure on a firm’s financial position can be far less troublesome.
Investing in long-term income
The payout ratio, cash balance, and debt profile are only the start of the analysis process. Using these traits to filter through high-yield dividend stocks can quickly remove unworthy candidates from the list. But there are plenty of other quantitative and qualitative factors to consider.
And even after finding top income stocks, the journey doesn’t end there. A thriving business today may suddenly be disrupted tomorrow. Overnight, an investment thesis could become invalidated.
Fortunately, diversification can cut this threat. Owning a range of high-quality companies across multiple industries operating in different locations can drastically reduce overall portfolio risk.
