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.