People invest in shares for different reasons. Some do it to grow their money over time. Others do it to get an income from what are called ‘dividends’. In fact, in recent years more and more people have been investing in shares that give good dividends and reinvesting the income to grow their money.
This MoneyMagpie guide to investing in high dividend shares will take you through the basics of shares and dividends and advise you on what to look out for when choosing a company to invest in.
- What are shares and dividends?
- Who would benefit?
- What do I get from it?
- Just how risky is it?
- What high dividend shares should I buy?
- How do I go about buying high dividend shares?
- Useful reads
A share is a portion of the value of a company that you are able to buy. Once you’ve bought a share you become a shareholder, which means that, in a way, you are now part of the company. As a shareholder you are a sort of part owner of that company. In simple terms, as the value of the company increases, the value of your share (or shares) increases.
A dividend is when a portion of the company’s profits are paid out to shareholders. The total amount of money you will receive if you own shares in the company is: the rate of the dividend x the number of your shares.
Ideally, if you’re investing in shares for their dividends you want a company that has a ‘high yield’. This means that they give a lot of money to shareholders each year compared to the price of their shares. So BP has a dividend yield of 4.98% and Tesco have a yield of 4.68%. The yield is the annual dividend amount as a proportion of the share price.
Not all companies pay dividends, some simply reinvest all their profit back into their business. You may suspect that a company that reinvested all its profits would ultimately be more successful than one that paid its shareholders but this is not always the case. In a 2003 paper two entrepreneurs argued that, historically, earning growth has been at its highest when payout ratios are at their highest. There are several reasons why this may be, but some suggest that when a company has to ensure a healthy payout to shareholders, it uses the smaller amount of profit leftover more efficiently.
Anyone who has a reasonable amount of cash that they want to get a decent income on could benefit from investing in high dividend shares.
In particular it might suit those who are retired, or about to retire, as it allows you to invest, sit back and, hopefully, get a good income from your pot.
However, it’s not an easy, risk-free option. Just because a company has regularly given good dividends each year it doesn’t necessarily mean that they will continue. Be aware it will still be important to keep an eye on the companies you invest in every few months so that you don’t get any nasty surprises down the line.
- You will usually receive your dividends payments twice a year.
- You can either receive the cash from your dividend, usually via an electronic funds transfer, or you can choose to reinvest in further shares.
- A lot of companies will let you reinvest automatically.
- Reinvesting in shares offers the greatest potential for return on your investment but cash payouts are good if you need the money soon.
There is always some risk in buying shares. You are dependent upon the company being successful and making a profit. No company is obliged to pay dividends, so there is never a guarantee. During the economic turmoil of 2009, 202 companies in the UK cut their dividends.
It must also be remembered that companies don’t like cutting their dividends as this will give them a bad reputation and can frighten away potential investors. That is why, even in a bad year, companies will tend to avoid cutting dividends and why, in a really good year, they still don’t increase them unless they are certain that they can do at least as well in the foreseeable future. No reputable company wants to be seen cutting dividends!
However, by picking wisely which company you wish to invest in, you reduce the risk significantly. You should:
- Look at their history of paying out dividends. Those that have regularly paid – and particularly those that have consistently increased their pay-out – are generally a good bet.
- Look at the sector they are in. The management of the company. Has it recently changed significantly or is it pretty stable? Stability is better than instability for investing.
- Look at the sector the company is in – e.g. oil and gas, media, retail. Is this a sector that is relatively stable or could there be big shocks which would affect the company’s ability to pay dividends?
Also, see below for more information on how to choose dividend shares.
Take a look at the company’s history
For a safe investment you should only consider companies that have consistently increased their dividends over the last twenty years. A company that regularly raises their dividends will also go some way to protecting against inflation. Take a look at the Dividend Champions list to see which companies have consistently raised their dividends. Be aware to look at how much they have been raised by, however, as some rises may not have been enough to protect against inflation.
You are best opting for a blue chip company, which means the company has a strong national reputation and is consistently able to operate profitably. Check out this site to search for blue chip companies.
Take a look at the company’s interest coverage ratio. The interest coverage ratio is used to determine the company’s ability to pay interest on its outstanding debt. It is calculated by dividing the company’s earnings before tax by the company’s interest expense of the same period. If the company can not cover its debts then it will not be able to pay you a dividend. An interest coverage ratio of 1.5 or lower is risky and, if you want a securer investment, you should be looking for a ratio of 3 or above.
Also check out the company’s sustainable growth rate. The sustainable growth rate is the maximum amount of growth a company is capable of without needing to borrow more money. Try looking for a growth of 7% or above for a safe investment. It is important, however, to ensure that this trend is likely to continue. A sudden change in legislation could stop certain company’s profits immediately and lead to dividends being cut or not given at all.
Look for lower payout ratios
A payout ratio is what percentage of the profits is paid out to the shareholders in dividends. A high payout ratio will be one that pays out a high percentage of the company’s profit to the shareholders. This may sound great, but it increases the risk for you as an investor. The higher the payout ratio, the more dependent the dividend will be upon the company making a good profit. Lower payout ratios are more secure and less likely to be affected by how much profit the company is making. To find out what company payout ratios currently are, you can go to Yahoo Finance. Forbes recommends that conservative investors should not go for a payout ratio that is higher than 60%. At the moment, for example, BP’s payout ratio is 29%.
It is advisable not to buy a stock when it is near its 52 week high. When the stock is at its highest, the dividend yield will be at its lowest. As an investor you want to buy at a low price and be able to sell at a high one. This is not an absolute rule, for example you shouldn’t just buy stock if it’s at its 52 week low because there may well be a reason why that share is being sold so cheaply. You can find current share prices on the London Stock Exchange website.
Invest in a company where the management receives dividends
It makes sense to invest in a company where the CEO receives dividends. They will likely be less inclined to cut the dividends as they too benefit from receiving them.
There’s no guaranteed way of ensuring you’ll make a good return, but if you follow this advice then you’re giving yourself some security. There are also more specific strategies that you can research and follow if you wish.
To buy shares you can usually go straight to a company’s website.
You can also use services such as computershare or shareprices and a top ten of share buying sites is available here.
Be aware there are often trading fees. Find out how much they are so you don’t lose your profit in trading costs!
There are several good books out there that will help you learn the basics of buying and trading high dividend stocks.
- Beat the Banks by Jasmine Birtles
- The Dividend Investor by Rodney Hobson
- Dividend Stocks for Dummies by Lawrence Carrel