When hunting for stocks that can provide dividend income, it's all too tempting to simply compare the headline yields of different companies. However, you can improve your chances of identifying companies that can pay strong dividends for a longer period by refining your method.
By also seeking out companies with a strong return on equity (ROE) you are more likely to find those businesses which will continue to be able to pay strong dividends in the future. Return on equity is simply net profit divided by average shareholder equity.
Rising profits on the same amount of equity means rising ROE. Stable profits generated using higher equity means a falling ROE. Therefore a higher ROE is generally an indicator of a more efficient, more sustainable business.
The three stocks on this list are very different, but each have ROE that is well above average, and dividend payouts that are less in danger of being cut (for the purposes of this article, all ROE data is taken from Commsec as at 26 April 2016).
The retailer
JB Hi-Fi Limited (ASX: JBH) is a familiar stock and business to many, but few would suspect that the cheap and cheerful store fitout hides a market-beating ROE.
For the past three years, JB Hi-Fi has consistently achieved ROE of above 40%, which is a sector-leading result. A focus on inventory control, disciplined management of costs and a growing online offering all mean that profits grow without the need for huge additional funds.
With a move into home appliances as a "store in store" concept within its existing sites, JB should be able to capture additional retail spending without having to invest in a costly new phase of store rollouts. JB currently trades with a solid dividend yield of 4.4%, fully franked.
The fund manager
Hunter Hall International Ltd (ASX: HHL) is one of several fund managers listed on the ASX. While it is less high profile than some of its peers, its share price has actually jumped over 50% in the past year, while other fund managers have struggled.
Funds management is an attractive business model with high operating leverage, which means that each dollar of additional profit costs less to generate, as efficiencies of scale are reached.
Hunter Hall achieved ROE of between 22% and 55% in the financial years between 2010 and 2013. Its most recent year ROE was only 11%, however. If its ROE can return to its historical levels, the dividend yield of 7.6% should prove very enticing to income investors.
The home builder
Tamawood Limited (ASX: TWD) is a home building and construction company with a difference. Instead of buying land, and developing large-scale projects and selling them like a traditional developer, it takes a different approach.
Tamawood contracts directly with home builders, providing affordable homes under the Dixon Homes brand. Instead of large scale multi-dwelling projects, Tamawood delivers single homes, which protects it from the worst of the swings of the building cycle.
It also operates a franchise model across Australia, where it uses its scale to buy building materials and supply those materials to its franchisees. This model means that the franchisees pay far less than they would if they were buying materials in lower volumes as independent contractors.
The value of this capital light strategy shows up in the numbers, with ROE between 60% and 75% in the past three years, alongside a current dividend of over 8%.
