Beware the High Yield Dividend Trap

The high yield dividend can be very enticing as an investor. Being able to secure a high dividend payment is an attractive option, however, you do not want to fall into the high yield dividend trap. If you are an investor in the stock market, you know that a company will issue dividends to their investors. Dividends offer a way for the company to share profit with the stock holders. If you are a shareholder, you are going to get a specific dividend payment for each share that you have.

High Yield

One of the primary objectives of investing in stocks is to realize capital appreciation. When you add in the dividends that you receive, this can make the stock even that much more attractive. The high yield makes investing in a particular stock that much more profitable. In order to calculate dividend yield, you can use a simple formula. Take the annual dividend per share, and divide that by the stock's price per share. 

Dividend Yield Trap

Using this formula can tell you which stocks have a good dividend yield. While this formula can be beneficial, it can also be detrimental. The denominator of this formula is the share price of the stock. This means that if the price of the stock goes down, the dividend yield is actually going to increase.

For example, let's say that a stock's annual dividend per share is $20. The stock price for the stock is $100 per share. This means that you would take $20 and divide it by $100, to get a yield of 20 percent. If the price of the stock plummets to $50 per share, you would then take $20 and divide it by $50. The new yield percentage is 40 percent. This might look attractive to you because it appears that the yield is increasing. The problem with this formula is that it actually rewards a stock for falling in price. In some cases, the company might be about ready to go out of business. However, it looks like the dividend yield is going up and many investors will be tricked into investing in that stock.

Considerations

Even though the dividends that a stock issues is important, there are many other variable that you will want to look at. For example, you will need to look at other valuation multiples such as the earnings per share, return on assets and the EBITDA. You should never make the decision purely on the dividend yield formula because it could result in putting money into a company that is declining rapidly.  

You may be better off to invest in companies that have high amounts of capital appreciation instead of issuing dividends. When you hang onto a stock for the long-term, you can realize capital appreciation from it. When this happens, you can pay taxes at the long-term capital gains tax rate which will be less than what you have to pay in taxes on the dividends that you receive.

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