The London Stock Exchange has quite a few companies with some of the highest dividends in the world. And that makes it a popular place for passive income investors. Considering that billions of pounds are paid yearly as dividends, these top UK’s best dividend stocks could provide a consistent income to investors.

Having said that, not every firm is a bargain. And there are undoubtedly a lot of traps that a dividend investor needs to be able to identify and avoid. Let’s take a closer look at the income opportunities within the United Kingdom.

What are high dividend yield stocks?

High-yield stocks refer to shares whose dividend yield is higher than the stock market benchmark. In the UK, this benchmark is typically the FTSE 100 index.

The average FTSE 100 dividend yield is expected to be around 4.1% by the end of 2022. This means that any dividend stock paying above 4% is among the UK shares with the highest dividends. However, this is a constantly changing figure since payouts can be raised, cut, suspended, or even outright cancelled. Therefore, it’s possible for once high-yield businesses to become less attractive in the future.

For investors in the United States, the most used benchmark is the S&P 500. By comparison, the average dividend yield across the pond is closer to around 2%. Why? Because companies in America typically prefer using share buybacks to return capital to shareholders instead of dividends due to tax benefits.

Regardless this class of stocks often attempt to maintain a high payout ratio versus the average. With that in mind, let’s look at how to spot which high dividend-paying companies are worthy of investment.

How to find good dividend-paying stocks?

Income investors aim to buy shares that will provide them with consistent dividends without much volatility in the stock price. Often this results in focusing only on a dividend aristocrat – a business that’s increased its annual dividend for 25 years in a row.

In the long term, this investing strategy has proven to be one of the best methods for accumulating wealth. But not every high dividend stock meets expectations. It’s important to remember that dividends are paid using excess capital, which a company doesn’t need anymore. Therefore if the revenue stream becomes compromised or profitability evaporates, the dividend income prospects are typically not far behind. Just take a look at what happened with travel stocks like Carnival in 2020.

In rare instances, a management team will try to protect payouts by taking on debt just to maintain payouts. However, in my experience, this is a recipe for long-term disaster and a giant red flag.

So, how can I tell the difference between a good and bad income opportunity for my portfolio?

• Consider long-term profitability – For any business to continuously pay dividends, it has to be profitable. From what I’ve seen, any group whose dividend payout ratio is gobbling up over 60% of earnings start looking unsustainable. The exception to this rule is real estate investment trusts, which must pay out 90% of profits to retain their tax benefits.
• Avoid large piles of debt – Even if a company is one of the highest dividend-paying stocks, this status will likely be short-lived if debt keeps piling up. Even more so today, given that interest rates are rising, putting even more pressure on profit margins. I always tend to avoid overleveraged firms with debt-to-equity ratios over 2.0.
• Watch out for industry trends – I always go for companies that are not so much affected by industry trends. In other words, I look for companies that could do well all year round. While my investment portfolio is diversified, my stocks with the highest dividends come from stocks that can perform consistently well.

When is a dividend yield a trap for investors to avoid?

One thing an income investor needs to avoid when searching for the best high-dividend stocks is the yield trap.

A yield trap is where a company uses a very high dividend to attract investors to a potentially troubled company. The idea is to make investors want to buy the stock for the dividend that it pays out. But these payouts often become unsustainable, resulting in an inevitable dividend cut. And in turn, the share price tumbles, amplifying losses in a portfolio.

Fortunately, these are pretty easy to spot in most cases. Using the three-point checklist I mentioned above will eliminate the vast majority of questionable dividend stocks from consideration. Another factor to verify is how the share price has moved in recent weeks.

Don’t forget that yield is a product of both dividend payout and share price. So if a stock suddenly drops, the yield surges up. But if the catalyst behind the share price drop is a fundamental problem with the business that impacts revenue and profits, then chances are it’s a trap.

Top 10 UK stocks with the highest dividends

The table below lists the top 10 UK stocks with the highest dividend yield as of today. The question investors need to ask themselves is which one of these firms can sustain their impressive payout and which ones are wealth-destroying traps.

RELATED: Top stocks with monthly dividends

Final thoughts

Dividends have remained one of the reliable ways to accumulate wealth. But not all stocks provide this source of income, and Warren Buffett is renowned for refusing to introduce dividend payments for Berkshire Hathaway shareholders. This is once again related to taxes. But in most instances, the firms that don’t pay, usually need the money to reinvest in themselves.

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.