Not all dividend shares are the same and investors looking for passive income need to look past initial appearances. But they can give themselves the best chance by avoiding some important miscalculations.
Mistake 1: forgetting where the dividend comes from
It’s easy to feel richer when dividend payments arrive. But investors shouldn’t forget that dividends are paid from a firm’s cash.
For example, when Games Workshop (LSE:GAW) paid its investors a dividend last month, they got 85p per share. But the company they own equity in has given away exactly that amount.
That means investors who see themselves as owners of a business – as Warren Buffett says they ought to – shouldn’t think they’ve got richer. All they’ve done is liquidate part of the asset they own.
Games Workshop has been an outstanding passive income investment. The popularity of its Warhammer products has allowed it to grow its dividend impressively over time.
In each case, however, the firm’s cash decreases by the amount it distributes. So receiving a dividend doesn’t make investors richer – it just transfers cash from an asset they own to their account.
Of course, investors can reinvest their dividends to boost their ownership of the company. But they’ll have to pay Stamp Duty on it, which means they’ll get slightly less in stock than they had in cash.
Owning Games Workshop shares has been a great way of building wealth over the last decade. But this is because its earnings have grown by over 1,000%, not because it has paid these out to investors.
Mistake 2: overemphasising dividend coverage
The dividend coverage ratio measures how much of a firm’s net income it pays out to investors. Strictly, the formula is: (net income – preferred dividends) ÷ dividends paid.
Investors often use this to try and gauge how sustainable a company’s distributions are. But it can be highly misleading.
Over the last 10 years, Games Workshop has distributed over 75% of its net income to shareholders. But the company’s low reinvestment requirements mean it can return most of its profits to investors.
That’s not to say the dividend is guaranteed – consumer spending in a recession is a constant risk for the business and this could weigh on distributions. But any cash it does generate can be distributed.
By contrast, shareholder distributions from Pennon Group have accounted for less than half of the firm’s net income. But it would be a mistake to think this means the dividend is less vulnerable.
The water utility has a lot of infrastructure to maintain and this requires a lot of cash. As a result, there’s a big gap between the earnings it reports and what it can return to investors.
Investors therefore need to avoid thinking that looking at the dividend coverage ratio is all there is to understanding how robust a dividend is. It can be a useful metric, but it can also be highly misleading.
Warren Buffett
Both of the mistakes above are ones Buffett has highlighted for investors. The Berkshire Hathaway CEO attributes the success of his firm’s investment in Coca-Cola to its growth, not its dividend.
Equally, Buffett puts the success of Apple down to the company’s low capital requirements. Dividend investors who follow these might not manage the same return, but they give themselves the best chance.
