Shares with high dividends. Good or bad sign?

When it comes to dividends, understanding the difference between dividend yield and dividend growth can be a key factor when deciding what companies to invest in.

• Dividend yield is calculated by dividing the annual dividend paid per individual share by the current share price
• Dividend growth is how much the annual dividend per share has increased from the previous year

But which do you think sounds better: 10 per cent dividend yield or 10 per cent dividend growth?

It might be natural to think income yield is better than income growth, particularly if the one stock is offering growth of around 2 per cent and another is offering a yield of 10 per cent, for example. However, high dividend yields are often the result of a falling share price and can be a warning sign that something is wrong with the company, meaning dividends could come under review at some point in the future.

Dividend growth is usually a better indicator of a sound company than high yield, particularly if there is a track record of year-on-year improvement in the level of cash paid to shareholders.

Use this check list when looking at any company that pays a dividend

1. Are earnings per share comfortably more than the dividend paid out?
2. Look at the company’s cash – if trading is poor, this raises the chance that there’s not enough cash being generated to make the expected pay-out. Don’t forget it is cash that pays the dividend.
3. A dividend yield above 8 per cent is rarely sustainable unless there’s significant levels of cash generation and the money isn’t needed elsewhere. (Even then – check to see if the company is reinvesting cash to sustain and grow its business. If it isn’t, then you should find out why not).

A useful test for dividend safety is to see how many times it is covered by forecast earnings. A ratio of two or more is considered reasonably safe. A figure below 1.2 could suggest the dividend, and potentially the company, has some issues.

For all these reasons it makes more sense to focus on sustainable dividend growth rather than worry too much over the starting yield. Sustainable dividend growth is typically a hallmark of a high quality company with the ability to generate plenty of cash flow. This may well be rewarded by a higher share price as investors rush to gain access to this cash flow and in turn deliver a capital gain to existing shareholders.

If you are in a position to reinvest the income from your holdings (known as dividend reinvestment), rather than taking the cash straight away, you’ll benefit by steadily increasing your exposure to an income stream which itself is already growing.