What to look for from dividend-paying stocks

With low interest rates, it appears very likely that dividend-paying shares will remain popular among yield hungry UK investors. Here’s what you need to know.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • What to think about when you're investing for income.
  • Tax implications to consider.
  • Why it's important to look out for 'dividend traps'.

Luckily, when it comes to sourcing dividends, there are plenty of potential candidates in the UK. Research from Capita Asset Services, shows that in early September 2016, the value of dividends paid since 2000 by Britain’s listed companies surpassed the £1 trillion mark.

Looking ahead, the firm expects UK dividends to reach a total of £2 trillion within the next 10 years.

Remember though, that these predictions aren’t guaranteed and dividends – like the value of the investments that produce them – can fall as well as rise. You could lose money and past performance isn’t a reliable guide to what might happen in the future.

But dividends aren’t just important to those who need an income, as you can always choose to re-invest them instead. In fact, research has often supported the view that re-invested dividends can potentially make a significant contribution to the total return from equities.

While some companies typically aim to increase their dividend payouts to shareholders every year – or at the very least maintain them – not all achieve this goal. If you’re looking to create your own portfolio of dividend paying stocks, it pays to do your homework and pick carefully.

Avoid the traps

The golden rule when hunting for income stocks is not to be tempted by so-called ‘dividend traps’. Just because a share offers a very high dividend, it doesn’t mean it’s a great investment.

Often, a rise in a share’s yield is a function of a falling share price, a sign that a company is in danger of cutting its payouts, or that it’s unlikely to grow its payouts further from their already lofty levels.

During the recent financial crisis many companies cut their dividends or even stopped payouts altogether. But even in more benign market conditions, there are plenty of signs to watch out for.

For example, when a company issues a profit warning it usually sets off alarm bells that its dividend could be in danger. Also, if a firm’s dividend is out of sync with its competitors’ payouts, that too could be a sign that all is not well.

Choose carefully

Before investing in any company, check whether earnings and revenues are growing and ensure it’s not overly burdened with debt. All of these factors have an impact on payouts.

But it’s not just about finding sustainable dividends. You should also seek firms that are set to increase their payouts in the future. Companies or groups with rising earnings and profits are much more likely to be able to raise their dividends because they have more cash on their balance sheet.

If you’re looking at a share for its income potential, always check its dividend cover. This is the most common way to see how robust and reliable a company’s shareholder payouts are going to be in the future.

You can work it out by dividing a company’s earnings per share (EPS) with its dividend per share (DPS). If a firm’s EPS is 100p and the DPS is 50p, then the dividend cover is two. A dividend cover of two or more generally points to a safer bet, while a firm with a cover of less than 1.5 could be a concern. But some companies, such as utility firms – which are renowned for having stable earnings – tend to be viewed as relatively solid payers, despite having lower cover levels.

Another way to find out how well a company’s earnings support its dividends is to look at the payout ratio. This is the dividend cover formula turned on its head – DPS divided by EPS. But the end result is the same – a dividend cover of two matches a payout ratio of 50%.

The upshot is that the wider the gap between the dividend and earnings, the more room a firm should have, in theory at least, to maintain its dividend if revenues and profits take a hit. Information on earnings, revenues, dividends and debt are available in company reports and on financial information websites such as Digital Look and Morningstar.

Tax on dividends

Dividends from UK companies generally don’t have tax deducted at source, but dividends from foreign companies might – it depends on their local rules. At present, in the UK the first £2,000 of dividends is tax-free, whatever rate of tax you pay, with the excess taxed at 7.5% for basic-rate taxpayers while higher and additional rate taxpayers pay 32.5% and 38.1% respectively. Any tax deducted at source under foreign rules may reduce the UK tax payable under UK rules. If you hold the shares in an ISA or a pension plan such as a SIPP then there’s no tax on dividends, and you can reclaim some deductions at source.

Find out more about Investment ISAs

Tax rules can change and the benefits and drawbacks of any particular tax treatment will vary with individual circumstances. If you have any queries about the legal or tax implications of any investment, seek independent professional advice.

Where to look

A number of industries such as tobacco and pharmaceuticals are well known for their dividends, but look at each potential investment on a case-by-case basis and examine the competitive advantage that one company has over others in its sector.

The world’s most famous investor, Warren Buffett, advocates looking for companies that enjoy an ‘economic moat’, by which he means firms with a very strong brand and competitive advantage in their marketplace.

Companies that fit into this category are most likely to not only sustain their dividends, but could increase them over time too. And this, if you’re looking for solid, dividend-paying stocks, makes them worth considering.

Bear in mind you could also get exposure to a basket of dividend paying shares by investing in a UK or global equity income fund.

An alternative way to get invested

If you have at least £5,000 to invest but want us to manage the investments for you, you might want to consider using our Plan & Invest service. Designed to take the time and hassle out of investing, if we think that investing is right for you, our experts create and manage a personalised Investment Plan, leaving you free to do what matters to you. Find out more about Plan & Invest.

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