It seems that lately, thanks largely to plummeting interest rates, dividend paying stocks are back in vogue — and in a big way.
The great irony, though, is that as investors have rushed to buy up income shares, they have pushed yields lower. Sydney Airports (ASX:SYD) is a great example.
This time last year, shares were trading on a trailing dividend yield of 5.2%. Although the group has since lifted its dividends, the 23%-odd jump in the share price has meant that the dividend yield has gone backwards — presently at 4.6%.
Of course, that's still quite respectable, but before you rush out to buy, remember that there are a host of factors that income hungry investors need to consider. In fact, a myopic focus on yield alone is likely to lead to some major mistakes.
Here are some of the more important considerations:
Franking Matters
As I discussed last week, franking credits make a huge difference to after tax returns. Sydney Airport is offering a great yield, but given its distributions are unfranked, it actually offer investors a lower after-tax yield than a 3.3% fully franked dividend.
Of course, that doesn't mean that franked dividends are always best — even without franking, Sydney airports still represents a better income return than, say, REA Group (ASX:REA), which offers a 1.7% fully franked yield. The important thing is to make sure you are comparing apples with apples. I won't go into the maths here, but dividing a fully franked yield by 0.7 will give you a figure that you can compare with unfranked yields.
Growth
A good starting yield is certainly important, but long term income investors still need to consider growth. For example, you may actually find you get a better income return from a low yielding but fast growing company, than you would from a mature business that offers a high yield but low growth.
Let's consider Carsales.com.au (ASX:CAR) and AGL Energy (ASX:AGL). 5 years ago, they were offering yields of about 2.6% and 4% respectively (both fully franked). And yet since then, Carsales.com.au has generated a better total yield than AGL, because whereas AGL has grown its annual dividends by an average of 3% per annum over that period, Carsales has managed a mammoth 20% average annual gain. Growth matters a lot, even for income investors.
Sustainability Of Dividends
Most brokers and websites will quote yields based on last year's dividends. It's a sensible convention that doesn't require any forecasts (which can be unreliable). However, that means that investors can be led astray if they look at yield without regard to the sustainability of dividends.
If you look for the yield offered by Metcash (ASX:MTS), chances are you'll see many sources quoting a yield of around 11%. And if you divide last year's dividends by the current price, that is exactly what you get.
However, what that figure fails to consider is that the company has decided to suspend its dividends for at least 2 years. Investor who didn't bother to do their research before buying shares in Metcash, are in for a rude surprise.
Volatility
Even if you find a high quality company, offering sustainable dividends and an attractive yield, you need to remember that share prices can be very volatile in the short term. There are undeniably some wonderful income opportunities out there at present, but the share market is no place to park your cash for theshort term. Whatever dividends you receive in the next year or two could be more than offset by a fall in the share price.
Of course, the share price of a quality company will likely recover in due course, but unless you are able to leave your investment untouched for at least a few years, there are better places for your cash.
Payout ratios
As income investors, we of course want the companies we are invested in to payout as much of their profits in dividends as possible. But we should also hope they maintain enough cash to properly support the business and its growth potential. Further, business can be bumpy, and it's nice to have somewhat of a 'cushion' against the ups and downs of company profits.
For example, Computershare (ASX:CPU) has not once been forced to cut its dividend since 2007 — despite the impact of the GFC and the fact that it experienced a couple of years of declining earnings. If it had paid out all of its earnings each year, dividends would almost certainly have been reduced.
At the same time, investors must be careful not to automatically assume that a high payout ratio (as defined by dividends/earnings) is always bad. IRESS (ASX:IRE) consistently pays out more in dividends than it reports in net profit each year. Normally, such a practice would be utterly unsustainable, but in this instance it relates to aggressive non-cash amortisation charges. In other words, if you look closely at the financial statements, you'll see there is ample free cash to sustain dividends, but that is disguised by the statutory results, which are weighed down by these non-cash impairments.
Foolish Takeaway
Investors are right to consider dividend yields when deciding what companies to invest in, but there is much more to the story.
At Motley Fool Dividend Investor, the service I run, we go well beyond yield to ensure that the companies we recommend not only quote attractive yields, but also have the capacity to deliver regular, reliable and rising income payments over time. It takes some digging, but it's well worth the effort.
