Why I wouldn’t always buy the highest-yielding dividend stocks for passive income

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Dividend stocks give me the opportunity to make passive income. Depending on my goals and funds that I can afford to invest, the type of stocks I choose will vary. However, regardless of the goal, I would rarely buy the stock that offers me the highest dividend yield in the entire FTSE 100 index. Let me explain why.

Understanding the dividend yield

Firstly, it’s important to understand how I calculate the yield for a dividend stock. To work out the current yield, I take the annual dividend per share and divide it by the share price. For example, if the total dividend paid over the last year is 10p and the share price is 100p, the dividend yield is 10%.

The reason why the calculation is important is because of how the yield changes. Two factors influence the movement of the yield. If the share price increases and the dividend remains constant, the dividend yield will fall. If the share price stays the same but the dividend decreases, the yield will fall. The opposite applies to both these cases as well, in which case the yield will rise.

Dividends don’t get paid or change that often, usually only a couple of times a year. So the main change in dividend stocks usually comes from the share price moving. This is why I need to be careful about stocks with a high dividend yield.

Potential issues

Dividend stocks with an exceptionally high yield might be this way because the share price has been falling. Such a fall will cause the yield to rise. On the face of it, I might just note the yield and think that it look fantastic. But digging deeper would show me the share price has been falling.

From here, I can do my research and work out why the share price has fallen. If the fundamental picture around the company has changed, this could be bad news. For example, poor results or revised profit guidance for the year ahead. In this case, it’s likely that the dividend per share will be cut in the near future. This will then lower the yield.

I want to avoid this situation occurring, because if the dividend gets cut completely I might need to sell the stock and look for a different one. Alternatively, the dividend might reduce, but the share price could keep falling. In this case, I could be left with a large unrealised loss from holding the stock that will take me years worth of dividend income to offset.

Sustainable dividend stocks

I can’t predict the future and what will happen to dividend stocks that I’m considering. However, I can take precautions to protect myself. In my opinion, current FTSE 100 stocks with a yield in excess of 10% would sound a warning bell in my head. 

I do admit that there are always exceptions, with some stocks offering a high dividend yield and maintaining this over time.

On balance, I’d much prefer to own dividend stocks with yields in the 5%-8% bracket that I think are more sustainable.

The post Why I wouldn’t always buy the highest-yielding dividend stocks for passive income appeared first on The Motley Fool UK.

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jonathansmith1 and The Motley Fool UK have no position in any share 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.

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