What Is a High-Yield Dividend?

As its name implies, a high-yield dividend is one that pays an above-average yield, which is the ratio of a stock's dividend to its price. What makes the phrase something of a moving target is a simple question -- what constitutes "average"? Certain investors have their own concrete definition, while others might set a rate that's much higher or lower. Institutional investors often fix their own levels.

As there's no hard and fast rule as to what constitutes a high-yield dividend, a good place to start is with the average yield of the stocks on the bellwether S&P 500 index. Let's begin there to explore how to plunge into high-yield dividend investing.

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Setting a benchmark for high-yield dividends

First, we'll take a step back and determine how to properly and accurately calculate dividend yield. Again, it's simply the dividend amount divided by the stock price. We have to be careful, though, because for the purposes of yield the dividend payout is always calculated on an annual basis, and most stocks pay quarterly (on relatively rare occasions, some dispense monthly or semi-annually).

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So, for example, if a company pays $0.25 per share every quarter, to calculate its yield we would need to annualize this to $1 ($0.25 per quarter times four quarters). With that, we divide by the stock's price to get the yield. For instance, if our example stock were $20 per share, we'd divide the annualized yield ($1) by the price ($20) to get 5%.

Now, back to determining what constitutes a high-yield dividend. So, the yield for all constituent stocks on the S&P 500 index is around 1.3%, a figure that jumps to roughly 2.3% if only dividend-paying stocks are averaged.

Using the latter range and rounding up, we can start to consider high-yield dividend stocks as being those that approach or exceed 3%.

Where can I find high-yield dividend stocks?

When we've established such a benchmark, the fun begins -- we can now start hunting for stocks that will pay us handsomely. Of course, as any seasoned income investor can attest, the gold standard is a high-yielder that not only doles out a generous distribution, but does so on a reliably regular basis.

Given that, why not make your first stop the ever-growing list of Dividend Kings? These are the star S&P 500 stocks that have increased their dividends at least once annually for a minimum of 50 years running. Of course, no company is guaranteed to maintain its dividend policy forever, but by and large these companies run businesses that are highly profitable and constantly throw off cash.

By my count, exactly 20 of the 55 Dividend Kings sport yields at or near that 3% threshold. Most of these will be familiar to American consumers. There's Coca-Cola and its eternal rival PepsiCo, currently yielding 2.9% and 4.3%, respectively. Popular retailer Target is on the list too, with a 4.6% payout, as is tobacco producer Altria Group and its thick 6.9% yield.

Once done with royalty, another good strategy for finding and zeroing-in on high-yield dividend payers is to explore an industry or stock market grouping that is habitually generous with payouts.

One example is the large cluster of real estate investment trusts (REITs) on the stock exchange. These companies, which invest in various types of properties and collect rent from tenants, are required to pay out at least 90% of their taxable net income in the form of shareholder dividends. That's a big number and it translates into high yields, given the sheer sizes of these payouts.

Happily for income investors, there are many REITs of various types readily available on the exchange. Do you feel that retail properties will hold their value, or even increase? A retail-focused REIT like Realty Income might be your thing, especially with its 5.6% yield (it's also one of those rare monthly dividend payers).

Other flavors of REITs abound, and they can get quite niche. Believers in the potential of the marijuana business might want to consider putting some coin into a REIT that holds only properties connected to the cannabis industry, for example. Step forward and wave to the folks, Innovative Industrial Properties; this is a pot REIT whose yield is a sky-high 13.3%.

A word of warning

This leads me to a note of caution: Exercise care with high yields like those in the double digits. Although this doesn't necessarily mark a struggling company, a far-above-average high yield dividend could indicate a business in trouble. Remember, yield is the annualized dividend divided by a stock's price, so if a stock experiences a pronounced sell-off, its yield can jump.

It's essential, then, to look behind a lofty percentage rate. Is it the result of smart, capable management running a sustainable and profitable business, or does it derive from a capsizing company that's on the decline? At the risk of stating the obvious, in doing your research you should consider eliminating the latter types from contention when considering high-yield dividend investments.

With that caveat, I'd say that there are more than a few attractive companies doing well enough to offer high-yield dividends -- even some that have kept their payouts notably airborne for sustained periods. Happy hunting, and don't spend all those dividends in one place!

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Eric Volkman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Realty Income and Target. The Motley Fool recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.