How to find shares with high dividend yields (that won’t let you down)
A dividend strategy that targets high yields in companies with good dividend cover, a solid payout record and strong financial health
Strategy brief
High dividend yields are attractive to investors who want to maximise their returns from shares. They can be a pointer to attractive cash payouts that can either be reinvested or used as a source of income. But the problem is that high yield can also be risky. In some cases it can be a signal that a dividend (and even the company paying it) are in trouble.
This strategy takes a cautious approach to high yield. It aims to find shares with high dividend yields that have a number of confirming features that offer confidence that the dividend (and the company itself) are safe.
With this strategy the objective is to find:
Company shares with dividend yields that are higher than the market average
Companies that can easily fund their dividends
Companies with a strong history of dividend payouts
Companies with robust and improving financial health
Background
Dividends are one of the two major sources of return you get from owning shares (the other being capital growth that comes from a rising share price).
One of the most important measures of a dividend is the yield, which is the ratio of a company’s annual dividend-per-share to its share price. Put simply, the higher the yield the bigger bang you get for your investing buck.
Yield is calculated like this:
Dividend yield = dividend-per-share / price-per-share x 100
Dividend yields are readily available on investment websites and brokerage platforms, but here’s an illustration of how to calculate both a dividend yield and a forecast dividend yield:
Last year, Company X paid a dividend-per-share of 11p
The current share price of Company X is 260p
The dividend yield calculation is 11 / 260 x 100 = 4.2%
The standard yield calculation is based on last year’s dividend-per-share. To calculate the forecast yield, use what the consensus of analysts believe the dividend will be in the coming full financial year.
In the coming year analysts expect Company X to pay a dividend-per-share of 12.1p
The current share price of Company X is 260p
The forecast dividend yield calculation is 12.1 / 260 x 100 = 4.6%
In cash terms, the bulk of dividends paid in the UK come from a handful of large FTSE 100 companies. But the majority of FTSE 350 companies pay some kind of dividend, and so do a number of small-cap and AIM-quoted companies.
Across the market as a whole - comprising more than 1,500 shares - just over a third pay a dividend.
Around the world, average dividend yields vary, with the US market currently averaging less than 2.0%, while most European markets average more than 3.0%.
How dividend yield works
By definition, the dividend yield on a share can be influenced by two factors:
The dividend rising or falling
The share price moving up or down
The first influence - the dividend rising or falling - tends to be infrequent. That is because dividend expectations are usually set half-yearly or yearly. Something usually has to go very well or very badly for companies to make changes outside of those normal times.
The second influence - the share price moving up or down - is constant, which means it has the greatest impact on the day-to-day movements in the yield.
How a moving share price affects the dividend yield
Here is how a moving share price influences a dividend yield:
When the share price falls, the dividend-per-share (or DPS) represents a greater percentage of it, which means the yield rises
When the share price rises, the DPS represents a smaller percentage of it and so the yield falls
Note! The connection between high yield and potentially cheap (or mispriced) shares is why dividend yield is commonly used in value investing strategies.
Because the share price plays a central role in the yield calculation, the crux of a high dividend yield strategy is to judge what the price is telling you about the market’s expectations for the company. It’s the job of the investor to decide whether the expectation (and the share price) are fair.
Market expectations are influenced by a host of factors, but there are three common drivers:
Company concerns
Sector concerns
Market concerns
Company concerns speak for themselves. If the market has detected a problem with the company, or is worried about its outlook (or its dividend), the share price will fall. This is central to the idea that high yield, whilst attractive, can actually lead you into a dividend trap. Troubled companies tend to slash dividends. But before they do, their high yields can deceive the unwary.
Share prices can also fall when investors take fright at the deteriorating outlook for specific industry sectors, or even the market as a whole. During these kinds of risk-off phases, indiscriminate selling can affect company shares that may or may not deserve it. Bearish phases can be painful for the market but they can also drive up yields and create potential mispricing - which creates an opportunity for dividend investors.
Where to find high yield shares
There are many reasons why a company's shares might have a high yield. Here are some of them:
Companies that have disappointed the market (or are predicted to miss expectations), resulting in a falling share price
Companies that are ‘sin stocks’ (they operate in controversial sectors like tobacco, alcoholic beverages, gambling or defence)
Companies in low-growth, highly predictable or highly regulated sectors like insurance and utilities
Companies in highly cyclical industry sectors that are prone to periodic downtrends
Companies where dividends are not expected to grow
Companies in sectors that face economic, geopolitical or other macro uncertainty
When to use this strategy
A high dividend yield can be a pointer to shares with high dividend payouts and to shares that are cheaply valued by the market. These two factors are attractive to many investors but they also come with risks (dividends might be cut and the cheap share might be in trouble).
This strategy focuses on the dividend aspect of high yield - finding shares that can be bought with strong dividend returns baked in. It is designed to help avoid future dividend cuts by looking for high yields on shares in companies with confirming quality features.
This strategy can be used at any time to sanity-check a yield and provide an important dividend assessment.
Strategy checklist
Searching for shares with above average dividend yields in companies that can afford to make the payouts from their earnings, have a solid track record of dividend payments and are in robust financial health.
1. Has the share got a high dividend yield (and high forecast dividend yield)?
The market average dividend yield is around 4.2%. High yield is usually seen as anything up to 8-10%, but it can go higher. With excessively high yields there is an increased risk that the dividend is unsustainable and the market is deeply concerned about something.
What to look for:
Does the company have a dividend yield greater the 4.2%?
Does the company have a dividend yield less than 10%?
Is the company’s forecast dividend yield within the same range?
2. Can the company fund the dividend from profits (with more to spare)?
Companies pay dividends from their net profits (ie. after all other expenses). Prior to being paid, the cash itself sits in ‘retained earnings’ in the shareholders’ equity section of the balance sheet.
If the current year earnings are not sufficient to cover the dividend, the company can dip into retained earnings from previous years, but this is unsustainable over time. If it’s desperate to keep the dividend intact, it might choose to borrow the money to make the payout, but this is even less sustainable.
With this in mind, a useful dividend quality check is to study the extent to which the company’s earnings can cover the payout. If it’s barely covered, it might be a cause for concern. But if it’s more than covered by earnings, it can be a confirmatory signal.
Some companies have specific policies on the proportion of earnings they will pay out as dividends, but many don’t.
There are two main ratios to consider: Dividend Cover and Dividend Payout Ratio. These ratios do the same thing but are calculated slightly differently.
What to look for:
Does the company have dividend cover of more than 1.5x earnings?
Dividend Cover Ratio = Net income / Dividend paid
The dividend cover ratio tells you the number of times the dividend could theoretically be paid from the company’s profits. At 1x, all earnings would be paid out. At 2x, the company would have twice as much as it needs to make the payout.
Does the company have a Dividend Payout Ratio of up to 50%?
Dividend Payout Ratio = Dividend paid / Net income
Like dividend cover, the dividend payout ratio is the proportion of earnings paid out as dividends. A payout ratio of 100% would indicate that all earnings are being paid as dividends, so you’d want to see it much less than that.
3. Has the company got a good history of dividend payments?
Consistency is a key indicator when it comes to dividend quality. A record of maintaining (and even growing) dividends every year can be a pointer to management discipline, a dependable, profitable business and consideration of shareholders.
Unpredictable events can disrupt even the strongest dividend growth records, but a record of regular payouts (even if they fluctuate occasionally) can be a positive signal. With a strong track record, management will often avoid making cuts where possible for fear of losing the faith of the market.
What to look for:
Does the company have a record of at least five years of dividend payments (preferably more)?
4. Is the company in good financial health?
A dividend strategy looking for high yield should check whether the company is in good financial health. Firms that are unprofitable (or where profits are declining), are over-indebted or have weakening balance sheets should be treated with caution.
One option is to use an accounting-based checklist like the Piotroski F-Score. If you don’t have access to the data and calculations for this, you can use your own version based on the same approach.
The idea is to check that the company is improving its balance sheet strength year-to-year in some important areas. This is a checklist you can use in almost any strategy, and it’s a useful guide to whether a dividend is sustainable (the more passes the better).
What to look for:
Is the company:
making a profit?
generating cash?
making more cash than it is reporting as profit?
more profitable than last year?
either cutting debt or keeping it under control?
increasing its ability to pay short term debts?
not having to raise funds from shareholders?
improving its pricing power and/or cutting costs (are its margins stable)?
more productive than last year?
Strategy risks
High dividend yields tend to grab the attention of investors, but it’s worth remembering that they almost always mean that the market has concerns. These can be at the company level, or extend to sector worries and even uncertainty across the whole market.
The key risk for investors is that the yield is a trap and that the dividend, and even the company paying it, is at risk. If you buy it and the dividend is cancelled, it’s possible that the share price will fall even further.
Remember that dividends are only one part of the ‘total’ return’ you get from shares. So paying attention to whether the company is in sound financial health is important.
Strategy summary
Dividends have broad appeal for investors. Downward pressure on prices - whether it’s in individual company shares, sectors or across the market - can raise yields. For investors, the question is whether the yield reflects a genuine mispricing in the shares, or whether there is an outsized risk of the dividend being cut.
Exceptionally high yields need a great deal of research and are almost certainly worth avoiding most of the time. But high yields in companies that don’t disappoint can make substantial contributions to your overall return.
A few important dividend checks covering the funding of the dividends, the track record and the financial strength of the company can offer clues to those that are genuinely good opportunities.