Investors need to tread carefully when yields on shares look too good to be true. Here are two shares to watch with caution.
There is something quite satisfying about dividends. In my view, dividend yield can be one of the most reliable methods of valuing shares. It allows investors to compare different shares in the same sector, different shares in different sectors and different market, too. It is even possible to compare shares against bonds, and to compare shares against property yields.
A high dividend can be a sign that a company is doing well, and that it is rewarding investors by paying out a significant proportion of its profits as dividends. According to Thomson Financial Datastream, around £46b a year is now paid out to stock market investors in dividends. This represents an average yield of around 3%.
However, averages can be deceptive because some companies are yielding well in excess of the market average.
Take power generator Drax Group
(LSE: DRX)
, which supplies around 7% of Britain's energy needs. Current forecasts suggest that Drax may pay a dividend of 121p per share this year, and a dividend of 100p has been pencilled in for 2007. This equates to a mouth-watering 11.1% forward yield on its shares, which cost 900p.
British Energy
(LSE: BGY)
, which supplies around a-sixth of Britain's electricity, is another high-yielding share. A dividend of 59p has been forecast for 2007 (rising to 75p in 2008). This implies a 9.3% forward yield on its shares, which stand at 634p.
Question is why are Drax and British Energy so cheap?
Part of the reason may be because both companies have colourful histories. Drax nearly went bust two years ago when its former US owner pulled the plug as energy prices slumped. In the case of British Energy, it collapsed after it failed to compete with other providers in a cut-throat energy market. So it is not surprising that investors have taken a cautious view.
Another reason may be that energy prices may fall. Significantly, power generators such as Drax sell their electricity in the wholesale market. Consequently, they cannot influence prices but are forced to accept prevailing prices. That said Drax has sold 65% of its contracted output for next year, and half of its output for 2008 already. Meanwhile, British Energy has fixed-priced contracts in place for over 70% of its output next year.
A third reason is the unpredictability of input costs. Drax highlighted fluctuations in gas, coal and carbon emission allowances as key variables that have affected forward dark green spreads. These spreads are the difference between the price of power and the cost of the raw materials required to generate the power. Ideally, power generators want to see rising spreads, which indicate high selling prices and low raw material costs.
Clearly, there are significant risks associated with the two power generators. They have little control over prices in the wholesale market apart from selling forward fixed-priced contracts. They also have limited control over input prices apart from agreeing to buy future raw material needs at today's prices.
As I see it, there are hazards behind the anomalously high yields at Drax and British Energy since no one can predict with certainty the direction of energy prices and the cost of coal, gas and uranium. So, while the yields are unquestionably high, investors need to carefully assess whether the value is real or wholly illusory. I suspect it may be the latter.
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