Is a higher dividend yield better? Not Always. Learn how to spot the good from the bad to avoid this costly mistake.

Investors Interested In Dividends Should Only Buy The Highest-Yielding Canadian Dividend Stocks If They Meet These Criteria—And Don’t Have These Risk Factors

Dividend yield is the percentage you get when you divide a company’s current yearly payment by its share price.

The best of the highest-yielding Canadian dividend stocks have a history of success

Follow our Successful Investor philosophy over long periods and we think you’ll likely achieve better-than-average investing results.

Our first rule tells you to buy high-quality, mostly dividend-paying stocks. These stocks have generally been succeeding in business for a decade or more, perhaps much longer. But in any case, they have shown that they have a durable business concept. They can wilt in economic and stock-market downturns, like any stock. But most thrive anew when the good times return, as they inevitably do.

Over long periods, you’ll probably find that a third of your stocks do about as well as you hoped, a third do better, and a third do worse. This is partly due to that random element in stock pricing that we’ve often mentioned. It also grows out of the proverbial “wisdom of the crowd.” The market makes pricing mistakes and continually reverses itself. But the collective opinion of all individuals buying and selling in the market eventually beats any single expert opinion.

Canadian dividend stocks and the dividend tax credit

Canadian taxpayers who hold Canadian dividend stocks get a special bonus. Their dividends can be eligible for the dividend tax credit in Canada. This dividend tax credit—which is available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will cut your effective tax rate.

That means dividend income will be taxed at a lower rate than the same amount of interest income. Investors in the highest tax bracket pay tax of around 29% on dividends, compared to 50% on interest income. At the same time, investors in the highest tax bracket pay tax on capital gains at a rate of about 25%.

The Canadian dividend tax credit is actually split between two tax credits. One is a provincial dividend tax credit and the other is a federal dividend tax credit. The provincial tax credit varies depending on where you live in Canada.

A couple of decades ago, you could assume that dividends would supply up to about one-third of the stock market’s total return. Dividend yields are generally lower today than they were a few years ago, but it’s still safe to assume that dividends will continue to supply perhaps a third of the market’s total return over the next few decades.

So apart from the Canadian dividend tax credit giving you a major tax-deferral opportunity, dividends can supply a big part of your overall long-term portfolio gains.

The highest-yielding Canadian dividend stocks can be riskier than they appear

Investors should avoid judging a company based solely on its dividend yield. That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend-paying stock’s yield could be high simply due to the fact that its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut. That’s why we recommend you look beyond dividend yield when making investment decisions, and look foremost for companies that have also established a sound business and a history of building revenue and cash flow.

More on danger signs when looking for the highest-yielding Canadian dividend stocks to buy

When looking for the highest-yielding Canadian dividend stocks, avoid the temptation of seeking out stocks with the highest yields—simply because they have above-average yields. That’s because—as we mentioned earlier—a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend.

Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks that have a high dividend payout that has been maintained or raised during economic or stock-market downturns. Generally, these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.

A track record of dividend payments is a strong sign of reliability and an indication that investing in the stock will most likely be profitable for you in the future.

Have you had a dividend stock that didn’t do as well as you hoped? Did you keep it or sell it?

Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was originally published published in December, 2021.  It is republished on the Hub with permission. 

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