Dividend yield: three tips to help build your investment wealth

In this second of our mini series on dividend investing, Alice Guy takes a look at dividend yield – what you need to know, what to watch out for and how you can use it to boost your investment wealth.

Dividend yield is a simple investing ratio that compares the price of a stock to its dividend pay-out. It's an important one to understand for any investor, especially if you're investing for income.

Dividend yield is affected by both dividends paid and share price: a company that pays an annual dividend of 5 per share and costs 100p per share will have a dividend yield of 5%.

Focusing on stocks with a high dividend yield is a tried and tested investing strategy with many keen advocates. It can provide a steady income that’s relatively unaffected by a volatile stock market. And reinvesting that dividend income can lead to healthy investing returns.

Our research shows that someone who invested £10,000 in the FTSE All-Share index in 1986 and spent their dividend income, would now have an investment pot worth £57,734. But if they reinvested their dividend income, that initial £10,000 would have grown to an astonishing £219,581 by June 2022.

However, dividend yield is not always all it seems. Here are three tips to help you avoid some common pitfalls and use dividend investing to build your long-term wealth.

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1) Dividend yield can be deceptive

As a long-term investor, it pays to do your research and not only look at dividend yield. That’s because a juicy dividend yield can hide a multitude of sins, as dividend yield will rise when the share price crashes.

For example, if a company pays a dividend of 5p for each share and its share price is currently 100p, then the dividend yield is 5%. If the share price crashes and drops to 50p, then the dividend yield would rise to 10%. The dividend yield looks great, but the company might be a risky investment choice. In a volatile market, this can be a particular issue as dividend pay-outs are historic, whereas share prices are based on current data.

That’s why it's important to look at a range of investing data before making an investment decision. Take time to check out industry news and consider other investing ratios like dividend cover - a measure of a company’s earnings over the dividends paid to shareholders.

A low dividend cover means a company might struggle to continue paying the same level of dividends in the future. Cover of less than 1.5 could indicate mean the dividend could be cut, while less than 1 indicates that the company is not making enough new money to pay the dividend. Safety conscious investors prefer dividend cover of 2 or more.

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2) High dividend yield companies aren’t necessarily low risk

Traditional investing wisdom often describes dividend investing as a low-risk slow, steady option, but that’s not necessarily the case. In fact, a quick look under the bonnet shows that some strong dividend payers might be an adventurous choice.

The UK housebuilder Persimmon (LSE:PSN) is a good case in point. The amazing 12.6% dividend yield is based on a share price that’s dropped 38.6% since January, following a downturn in revenues and houses built during the first half of the year.

There's also a possibility that dividends could fall in the future if earnings don’t pick up, as the current dividend cover ratio is only 1.05 compared with 2.1 for Barratt Developments (LSE:BDEV) and 2.1 for Taylor Wimpey (LSE:TW.). At the newly reduced share price and with a chronic UK housing shortage, Persimmon may still be an attractive long-term prospect, but recent volatility shows it’s not necessarily a slow and steady low-risk option.

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3) Consider out-of-favour UK stocks

Long out of favour, the UK stock market could providerich pickings for dividend investors: the value-heavy FTSE 100 index is full of long-established high dividend payers. It has an average dividend yield of around 4% per year compared with the 1.5% yield of the S&P 500 growth-focused index.

The UK market also looks good value for long-term investors, with an average price/earnings (PE) ratio of 14.3 for the FTSE All-Share index, compared with 19.5 for the US based S&P 500 index. The PE ratio measures a stock price divided by a firm's yearly earnings per share. It’s a measure of how many years it will take the investor to earn back their initial stake (assuming the company pays out 100% of its profits in dividends – which never happens in practice).

Unlike the S&P 500, FTSE 100 share prices are largely based on current revenues and an established pattern of dividend payments. And, in this volatile and high-inflationary environment, the relative security of the UK stock market looks increasingly attractive.

• Read the first article in the series here: Dividend investing: three tips for a comfortable retirement income