One of the rewarding things about owning shares can be the payments I receive as a shareholder. Not all shares pay dividends, but many do – and they can add up.
If I had a spare £1,000 to invest in dividend shares and wanted to target an annual yield of 7%, here is how I would go about it.
Looking for robust businesses
Earning dividends next year would be good. But as a long-term investor, my field of vision is much bigger than that. I would like to find dividend shares that hopefully pay out for many years to come. As dividends are never guaranteed though, what should I look for?
To begin, I would consider areas where I expect there to be robust customer demand. From electricity generation and distribution to shampoo sales, I see many such fields. I do not fully understand all of them though, which can make assessing commercial prospects challenging. So I focus on areas I do understand.
Next, I would look for companies within those areas that have a competitive advantage. That gives them pricing power, something that can help power future profits – and dividends. For example, in the area of electricity distribution, the network owned by National Grid is one of a kind.
Valuation matters
But simply finding a good business I think could pay beefy dividends is not enough. Valuation also matters. If I overpay for shares, even if they offer good dividends, I may end up in the red overall due to a falling share price.
So I would look for dividend shares that have a compelling investment case but sell at what I think is an attractive price. For my portfolio, that rules out shares like Judges Scientific. I think it is a great business – and has been a steady dividend raiser, but the valuation looks too high for my tastes, with a price-to-earnings ratio over 50.
The role of yield
Even if Judges was trading at an attractive valuation, it would not be among the dividend shares I would buy to target a 7% yield. It yields less than 1%.
My target of 7% is only an average, so I could invest in shares with a range of yields. But a very low yield like the one offered at Judges would not make the cut. However, as I explained above, I would not start with yield. Instead I would focus on finding the right sorts of companies with attractive valuations. Only then would I consider their yield.
I think a 7% average yield from quality companies is possible. I currently own blue-chip FTSE 100 shares with a higher yield than that, such as M&G.
Buying a range of dividend shares
However, I would want to reduce my risk by diversifying across a range of dividend shares. £1,000 may not sound like a lot of money for this – but I think it is enough.
I could split it evenly across two, three, or four different companies, for example. By spreading my money over a range of promising shares, I believe I would have a high chance of hitting my target dividend yield.
