Across the globe, monetary policy is exceptionally loose. This means that interest rates are low and the return on cash and bonds is somewhat disappointing. As a result, high dividend paying shares have become increasingly popular and look set to remain so in the coming years. With that in mind, here’s how you can boost your income return.
It may sound obvious, but seeking out companies with high headline yields is the easiest and most effective means of boosting your income return. Clearly, a stock that pays 5% is a more appealing option than a company that pays 3%. However, the reality is that a stock’s headline yield may be somewhat misleading.
That’s because a company may be struggling financially because of challenges in the industry in which it operates, or for some other reason. Therefore, a 5% yield may have been affordable last year, but has become unaffordable in the current year or in the next financial year. Therefore, it is crucial to check on a company’s forecasts and to also assess its capacity to meet the current headline yield.
One means of ascertaining how affordable a company’s dividend is to check the dividend coverage ratio. This simply divides net profit by dividends paid. A figure of above one indicates that the current level of dividend is sustainable, while a figure below one shows that the company in question is paying out more in dividends than it is generating in profit.
This situation will require either increased borrowing or a dividend cut in the long run. However, even a dividend which is covered more than once can be unacceptable based on a company’s risk profile. For example, a highly cyclical company may have a dividend coverage ratio of 1.3, which indicates that its dividend is sustainable at the current level. However, in more challenging years its profit could halve and this may cause its dividend to be cut in the short run.
Similarly, for more stable stocks such as utility and tobacco companies, a narrower dividend coverage ratio may prove to be acceptable. After all, demand for those products and services is unlikely to endure a hugely difficult outlook.
Perhaps the facet of income investing that is most frequently overlooked is the prospect for dividend growth. For long-term investors, this can be more important than the headline yield since a rapidly growing dividend could create an ultra-high yield stock for the investor.
Clearly, an investor must make an assessment of a company’s future outlook in terms of its competitive advantage and earnings growth potential in order to predict its dividend growth prospects. However, a company which has a high dividend coverage ratio, sound finances and is transitioning from being a growth company to a more mature company is relatively likely to increase dividends at a brisk pace in future years.
So, by focusing on a mixture of the headline yield, dividend coverage ratio and a company’s dividend growth potential, it is possible to boost your income returns.
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Fool contributor Peter Stephens has no position in any stocks mentioned.