As deposit accounts pay very low interests or next to nothing, dividends on shares seem attractive. But you'll need to choose carefully.
Many large companies pay decent dividends once, twice or even four times a year. The yield – the dividend expressed as a percentage of the share price – is often attractive by comparison with interest rates on savings. There are now a wide range of blue chip companies yielding 4pc.
Warnings for those seeking Dividend Yield in their investing
When comparing a dividend yield with the interest rate on a savings account, however, certain warnings should be borne in mind.
1. The first point is that your capital is not guaranteed; share prices can and do fall.
2. Secondly, dividends can be cut drastically or axed altogether with little or no notice – and this can lead to a fall in the share price as well.
So just buying the shares with the highest dividend, without researching how safe that dividend is, can be a mistake.
There are now a huge range of high yielding blue chips but it is best to look for a dividend that is less likely to be cut even if that company's profits fall.
A high yield alone is not synonymous with a decent dividend.
If you carry out thorough research and pick the right shares, you will get better value for your cash than by leaving it in a savings account.
Measure of a dividend's reliability is Dividend Cover
The long-established measure of a dividend's reliability is dividend cover: the ratio of net profits to the size of the dividend payout.
Generally, a cover ratio of at least two – meaning that the company has twice as much net earnings as the amount earmarked for dividend payments – is considered a strong indicator.
Once again, for those who invest for yield or income - either Dividend Yield Investing or Dividend Growth Investing - STOCK SELECTION is still the key.
Search out for those companies that have a good chance of sustaining or even increasing their dividends.
If you are knowledgeable, you can even anticipate and avoid those companies that may skip or reduce their dividends in the future.
Stock selection is the key to dividend yield investing.
Some investors look at historic yields; some at forecast (or "prospective") yields.
But either way, those yields can be unexploded mines, lurking for the unwary.
Looking at yield on its own, in short, can quickly introduce you -- painfully -- to the meaning of the term "yield trap".
Yield Trap
The yield trap is simply explained.
You buy a share, attracted by the high yield. But the dividend is then cut, or cancelled -- leaving you without the anticipated income. Worse, unsupported by the payout, the share price usually falls as well, leaving you also nursing a capital loss.
Let's see it in action.
Company A pays out 9 pence a share, with shares changing hands for 100 pence per share. So the dividend yield -- which is the dividend per share, divided by the share price, and multiplied by a hundred to turn it into a percentage -- is 9%.
But that 9 pence is unsustainable. Company A then halves its dividend, slashing investors' income. What happens to the yield? If the share drops to -- say -- 80 pence, the historic yield the becomes 5.6%. The "yield on cost" figure, of course, is 4.5%.
How, then, should investors spot potential yield traps? Answer: Dividend cover
The most obvious reason for slashing the dividend is that the business simply hasn't got the money to pay it.
The business's earnings, in short, aren't large enough to support a distribution to shareholders at historic levels.
Put another way, actual earnings per share aren't sufficiently large when compared to the anticipated dividend per share.
Which is where the notion of 'dividend cover' comes in: earnings per share divided by dividend per share.
Interpret Dividend Cover with care
Now, dividend cover shouldn't be followed blindly.
Some businesses -- such as utilities, for instance -- can quite happily operate with lower levels of dividend cover than more cyclical businesses.
Other businesses -- such as REITs -- must pay out a fixed proportion of earnings as dividends, so again a low level of dividend cover is the norm.
Still other businesses have very high levels of dividend cover, because they are growing -- and therefore retaining earnings for future investment -- rather than paying them out as dividends.
But as a broad brush generalisation,
- A ratio of close to one is definitely the danger zone.
- A ratio much bigger than two indicates a certain parsimony.
- A ratio of 1.5-2.5 is usually what I'm looking for.
Stock Performance Guide on Dividends (by Neoh Soon Kean)
He considers dividend per share (DPS) as the most important factor when evaluating the worth of a share.
The ideal situation is for the DPS of a company to grow smoothly and rapidly over the years. (This is the Dividend Growth Investing I mentioned).
The DPS track record should be unbroken for many years.
One important caveat: you must compare the amount of dividend paid with the amount of earnings per share (EPS). (This is the dividend payout ratio).
- The growth of DPS must be proportionate to the growth of EPS.
- A company cannot sustain year after year of higher DPS thanEPS.
- On the other hand, the DPS should not be too small compared with the EPS unless the EPS is growing rapidly.
He advises, under normal circumstances, the DPS should be between 30% to 70% of the EPS.
Happy Investing
