Many investors, myself included, look to allocate a proportion of their portfolio towards high-dividend-yield stocks. Why? Well it helps to have your money generating regular income when the company you have invested in pays out a dividend, rather than just waiting for the share price to go up.
This dividend yield is (hopefully) higher than the interest rate you could achieve by holding a Cash ISA, so the opportunity cost is small. Obviously there is higher risk when you try to attract a higher yield, and this is what investors need to weigh up.
A perfect example of this risk/reward concept can be seen from the current highest dividend yield stock in the FTSE 250, New River Retail (LSE: NRR). It has a mouth-watering yield of 11.42%, according to current calculations. But before you jump in and buy as much as you can, let’s take a closer look.
Is there such a thing as too high a yield?
The dividend yield calculation is fairly straightforward. Essentially you divide the dividend paid out over a year by the current stock price. So if a stock was trading at 100p per share, and the dividend paid annually was 10p, the yield would be 10%.
Yet dividend yields can be misleading because a company that has a high dividend yield might actually be best avoided. It is not always the case, but a very high yield is frequently a warning signal.
For example, if the fictional share mentioned above started to have a lot of problems and the share price dropped to 80p, but the dividend paid was still 10p, the yield would have now risen to 12.5%. Clearly, in this scenario, this would not be a buying signal as your dividend yield could be offset by the share price potentially continuing to fall.
A case in point is New River as its share price dropped to all-time lows this summer and has only recovered partially. If you feel it is undervalued, it could be a great call, however do be mindful that the yield may be elevated due to the share price fall.
Would I buy New River?
Before I make the call, the other point I want to stress is that New River is fairly unique in that it operates as a REIT. This stands for real estate investment trust, meaning the business invests in property. For tax reasons, it needs to distribute 90% of its earnings per year, usually in quarterly instalments. Therefore, REIT’s do tend to offer a high dividend, and indeed high dividend yield, due to this fact.
Personally, I would not buy into New River, despite the lofty yield. This is because I feel the UK commercial property market (which it invests in) could be due a pullback, with several risk events on the horizon. With correlation to the residential property market as well, fellow readers may feel they already have enough exposure via their own properties.
I am not saying New River is a flawed business, but I do think this highlights that just buying a company due to the dividend yield alone is not always the best idea.
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Jonathan Smith and The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.