Investing for dividends – what you need to know

There are two ways to make money holding shares – selling them when the price goes up or collecting dividends. In an ideal world, a stock would offer growth and income with a rising share price and a constant stream of dividend payments. But in practice it’s not so easy.

Dividend-paying companies share a portion of their profits with investors through dividend payments. The more reliable their dividend, the more investors are typically willing to pay for them. However, no dividend is ever guaranteed.

With costs soaring, it’s become much more difficult to find stocks paying a dividend that beats inflation. While it might be tempting to trawl through the markets looking for inflation-busting yields, there are a few things to look out for before snapping up a dividend stock.

This isn’t personal advice. If you’re not sure what’s right for you, seek advice. Remember all investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. Yields are variable and are not a reliable indicator of future income. No dividend is ever guaranteed.

Making sense of yield

Dividends can be expressed in absolute terms, 4p per share, or as a percentage of the share price as a yield. The latter is a more useful way to compare dividends. That’s because a 4p dividend from a stock that costs £4 yields one percent, but a 4p dividend from a stock that costs 40p offers a 10% yield.

You can’t just search for the highest yields in the market and call it a day, though. The yield is sensitive to the share price – so a stock whose share price has fallen considerably will have a higher yield than one that’s risen. If the depressed share price is the result of underlying weakness in the business, chances are that dividend won’t be around much longer or at least at the same level.

The type of yield is also important.

A trailing, or historic, yield looks back at dividend payments over the past year, with respect to the current stock price. This is the most common figure you’ll see displayed and is what’s available on the share factsheets on our website. This is a useful touchpoint, but past pay-outs don’t necessarily reflect what’s to come.

Lots of stocks with the largest yields come from industries that wax and wane with the economy. When times are good, they bring in a lot of excess cash and much of it will be funnelled into shareholders’ pockets. However, the reverse is also true.

We find it more useful to look at prospective dividend yields. These take into account consensus forecasts for dividend payments over the next year and compare them to the current stock price. Again, this isn’t an exact science, but it’s a good way to get a sense of what might happen.

You can find the prospective dividend yield and more on all of our share research notes for the 100+ shares we cover. To get up-to-date share research and helpful guides like this one delivered straight to your inbox, sign up to our Share Insight email.

Dividend coverage

Now that you’ve got an idea of how much a company’s paying out, it’s time to evaluate whether or not this is sustainable.

Sometimes companies going through a rough patch will have to dip into debt to cover their dividend pay-outs. This is like paying off a loan using a credit card and is typically a red flag. It’s not a sustainable way to reward shareholders, and will most likely end with the dividend being cut, unless sufficient cashflows materialise to pay down debt.

For that reason, dividend investors often use a coverage ratio to determine whether or not a company can keep up its dividend. The coverage ratio tells you how many times a company can pay its dividend using profits.

The most basic version looks at net profit divided by the total value of dividends paid.

A coverage ratio of 1 means the company is paying out all of its profits. That could indicate the company isn’t investing at all (or at least very little) in future growth. While dividends are a good way to profit from your investments, they shouldn’t come at the expense of the company’s long-term future. We think generally speaking, a coverage ratio of 1.5 generally indicates a more sustainable dividend.

Net debt vs. cash profits

Another way to see whether a company has the means to keep up with dividend payments is to look at debt.

We like to use net debt because it considers any cash, or cash equivalents, as well. It’s the sum of all outstanding, interest baring, loans less any cash or cash equivalents. It tells you how much debt would be left if the company paid all its loans using easy access savings.

By comparing net debt to underlying cash profits (EBITDA), you get a snapshot of a company’s financial health. If the ratio’s under 1, it means the company’s cash profits can cover all of its obligations. Anything over 2 is worth investigating further. It can also be a sign of trouble if this ratio is consistently increasing over time.

Companies with a high net debt to EBITDA ratio are more likely to reduce their dividend payments in the future to keep up with loan repayments. This is particularly true if they’re holding a lot of short-term or index-linked debt. As rates rise, that debt will become more expensive and paying it down could take priority over shareholder returns.

The pay-out policy

It’s also important to fully understand the pay-out policy for dividend stocks. Those with relatively high yields tend to spell out their dividend intentions in their updates. Some companies will pay out a certain percentage of free cashflow, while others base their policy on the bottom line. In other cases, management will pledge to up its dividend payments by a certain percentage every year.

This will give you some idea of what to expect. Remember though, nothing is guaranteed. Dividends tend to be first on the chopping block when times get rough, regardless of the policy.

The bottom line on dividends

Dividends are an important part of building a portfolio, but they shouldn’t be the only thing you consider when making investment decisions.

Shareholder returns come in many forms – some companies repurchase shares rather than paying a dividend as a one-off way to increase the value of remaining shares. Others reinvest all of their spare cash into growth opportunities, which if deployed wisely will ultimately generate better overall returns.

Still, if steady income is what you’re after, dividend stocks can be a good way to help achieve that. But it’s essential to dig beyond the advertised yield before making a decision and review your investments regularly.

Investing in individual companies isn’t right for everyone – it’s higher risk than investing in funds as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

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