Despite what you might hear from the financial media who have been quick to talk about dividend-paying shares as if they were a separate asset class, dividend-paying shares are not a monolith. They don’t trade in lockstep with each other any more than do two shares that use buybacks instead of dividends, or a gilt and non-investment grade bond.

Indeed, a share that trades with a 2% dividend yield probably has very little in common with a share that yields 6%. All else being equal, the two companies are likely at different stages in their growth cycles, have different risk profiles, and different dividend policies.

The simplest way to start classifying dividend-paying shares is to find the market average yield (we’ll use the FTSE All-Share), which is currently 3.5%, and call everything above the average ‘high yield’ and everything under it ‘low yield’.

Yet even that classification can be misleading, though, as there are extremes on both sides to consider, as well.

Four types of dividend shares

I reckon we can use four yield categories to establish a reasonably accurate matrix for understanding the spectrum of dividend-paying shares.

Yield category Dividend yield range Translation
Afterthoughts <2% Likely a company in a growth phase; yields are so low that dividends are likely not a part of your main investing thesis.
Dividend growth 2% to 1.2x market average Likely a company in the mature growth phase; expectation that the share will provide a higher income in 5-10 years.
High yield 1.2-2x market average Likely a company growing near the GDP rate; your expectation is to harvest high levels of current income.
Stratospheric >2x Market Average Likely a company in decline or in financial trouble; higher risk of dividend cuts.

Yield ranges as of 10/10/2012.

These are generalisations, of course, and there are always exceptions, but it’s still helpful to see that dividend yields can usually tell us quite a lot about a share.

Perhaps most importantly, it helps set expectations. You shouldn’t buy a share in the high-yield category, for example, expecting 15% annualised dividend growth. It’s simply not likely.

Avoid the extremes

We can set aside ‘afterthoughts’ for our discussion here. Investors primarily interested in dividend-paying shares for income won’t likely waste their time with such low yields.

To see why, consider the following chart tracking income in three scenarios over a decade:

  • 1% yield growing at 15% annualised
  • 3% yield growing at 9% annualised
  • 5% yield growing at 4% annualised

As you can see, even after a decade of 15% annualised growth – a very high growth rate – the share yielding 1% today will still produce far less than the annual income of the other two yield scenarios. Consequently, the low-yielding ‘afterthoughts’ are just not of interest to dividend-minded investors.

We can also set aside stratospheric yielding shares for now. These are shares yielding more than 8% in today’s market – or roughly twice the average. Such ultra-high yields are a special case unto themselves, and they require a distinct analysis. The alluring high levels of current income the stratospheric yielders appear to offer is likely to be unsustainable in the medium-term, and as such investors should approach them with the utmost caution and not purchase them for yield alone.

Having eliminated the two extremes, we can focus on the sweet spot of the dividend yield spectrum – the ‘dividend growth’ and ‘high yield’ categories.

I believe an investor looking to build a portfolio that generates a sustainable and growing stream of income is best served by focusing on these two categories. You should find plenty of selection here without taking undue risk.

Dividend growth shares

What we’ll generally find with dividend growth shares – which in today’s environment are shares yielding between 2% and 4% – are companies that have passed their high-growth stages but continue to retain a significant percentage of their earnings to reinvest in the businesses.

In this space, dividend cover ratios are usually at least 1.8-2 times.

A few classic dividend growth examples today might include Domino Printing Sciences (DNO), London Stock Exchange (LSE), and Diageo (DGE).

The trick with dividend growth shares is, well, the growth part!

Since you’re forgoing a little jam today in hope of more jam tomorrow, you want to feel confident that there will in fact be more jam in a few years’ time. After all, a share yielding 3% and growing its annual payout below the rate of inflation won’t do an income-seeker much good.

Ideally, you want dividend growth shares to offer at least three percentage points above inflation. With RPI inflation coming in at 2.9% in August, for example, that means you’ll want to target at least 6% annualised dividend growth from shares in this category.

In future posts, we’ll discuss more tools for analysing dividend shares, but one way to get a better idea of a share’s dividend growth potential is to determine the company’s sustainable growth rate (SGR).

To arrive at the SGR, take the five-year average return on equity and multiply it by the most recent retention ratio (1 – dividend payout ratio).

What the SGR is telling you is the maximum rate the company can grow without changing its financial leverage (increasing/decreasing debt, etc.)

For example, if the company’s average return on equity has been 15% and it is retaining 50% of its earnings, the sustainable growth rate is 7.5%.

If you’re researching a share in this category, one of the things you want to ensure is that SGR is above your annualised dividend growth threshold. Certainly there are other factors to consider before making a buying decision, but SGR is an important one.

High yield shares

Investors who prefer their jam today will likely focus on the high-yield area of the market, which as I write ranges from around 4% to 7%.

For a real-life example of such a portfolio, check out The Investor’s demo HYP here on Monevator.

Companies that fall into the high yield category have likely passed their above-average growth days and have now settled into growing more or less at the rate of the broader economy.

Classic high-yield mainstays in today’s market include SSE (SSE), Vodafone (VOD), and AstraZeneca (AZN).

When analysing high yield shares, it’s critical to keep a few things in mind. First and foremost, your focus shouldn’t be so much on growth potential, but sustainability of the dividend. As such, more emphasis should be placed on the strength of balance sheet and free cash flow cover.

To gauge balance sheet strength, I recommend considering the quick ratio ((current assets-inventory)/current liabilities) for short-term liquidity analysis and the interest coverage ratio (EBIT/interest expense) and debt-to-EBITDA ratios for longer-term credit analysis.

A company with a strong balance sheet will typically have a quick ratio above 1 times, interest coverage above 3 times, and debt-to-EBITDA below 2 times. For free cash flow cover, look for at least 1.5 times.

Slight variance around those figures is fine and it’s important to compare these ratios with competitors’ ratios, as well. Most utilities will have debt-to-EBITDA ratios above 2 times and free cash flow cover close to 1, for instance, but that doesn’t mean they all have terrible balance sheets or unsustainable dividends. The regulated nature of some utility operations allows for a little more leverage. In cases like this, focus your attention on shares with the best relative metrics to the industry average.

Second, it’s important to determine how a company entered the high-yield area of the market. Because yield and share price have an inverse relationship, it’s often the case that a high yield share was a dividend growth share whose yield increased as the result of a depressed share price and not a more generous dividend policy. If this is the case, be sure you understand why the market sold off the share.

Third, there tends to be a limited number of ‘quality’ high-yield shares and they tend to be concentrated in just a few sectors. Investors should be careful not to overload their portfolios in just a few shares or sectors to maximise yield. Diversification is always important.

Finally, since high yield shares tend to be slow-growers, management teams at these companies may opt to make silly and large acquisitions in order to jump-start growth. This strategy usually means bad news for shareholders — the company overpays, can’t achieve its synergy goals, etc. — and the dividend could be at risk if the move turns out to be particularly bad. Be extra cautious around companies with the habit of making sizeable acquisitions to fuel growth.

Roll your own dividend investing strategy

One of the nice things about building an income-focused portfolio is that you can mix dividend growth and high yield shares to meet your specific goals.

If you’d like a little more current income, for example, but still have a longer-term time horizon, you might put 70% in high yield shares and 30% in dividend growth shares. The possibilities are endless.

The Analyst owns shares of SSE and AstraZeneca. You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

Further reading:

  1. What is dividend yield?
  2. How to calculate the dividend yield
  3. Decoding a company’s dividend policy

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