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How To Find The Best Income Stocks For Your ISA

The tax-free nature of an ISA means that it’s perfect for income investors, no matter which income tax bracket you fall into.

However, you need to be careful which dividend stocks you choose for your ISA wrapper. Indeed, while it’s true that many companies currently support dividend yields of 3% to 6%, easily beating the rate of interest on offer for many cash ISA’s, it’s never a good idea to chase yield.

You shouldn’t buy a stock just because it has a high dividend yield, without first assessing the underlying business and sustainability of the payout.

Still, there are some stocks out there that offer higher than average dividend yields that are sustainable; you just need to know where to look.

Safe dividends

The best place to start assessing the sustainability of any dividend payout is the dividend cover. Dividend cover provides an indication of how many times a company’s dividend payout is covered by earnings or profit generated from operations.

A ratio of less than one indicates that the company’s dividend payout is greater than its net income, meaning that the payout is being made from cash reserves or even debt.

Paying a dividend from reserves or borrowing to fund the payout is not sustainable over the long term. So any company with a dividend cover of less than one should be avoided.

The ideal dividend cover would be two or more. In other words, the company’s dividend payout should, in a perfect world, be covered twice by earnings per share. However, this figure will vary depending on which sector the company operates in. For example, a defensive company like National Grid, with a predictable income stream, can afford to return the majority of its earnings to investors. National Grid’s dividend is covered one-and-a-half times by earnings per share. The company currently supports a dividend yield of 4.7%.

On the other hand, high-street bookie Ladbrokes does not have a defensive business model and the company’s income is erratic. Therefore, the company’s dividend cover of 1.1 seems too low and indicates that the payout could be for the chop if trading deteriorates. This is why the company’s dividend yield, which currently stands at 8% is misleading. Actually, City analysts already expect the company to slash its dividend payout by around 20% this year.

Best picks

So, which stocks off the highest dividend yields with the best cover? Well, high-street retailer Debenhams currently offers a yield of 4.3%, and the payout is covered twice by earnings per shares.

Lloyd’s of London insurer Catlin currently offers a dividend yield of just under 5%, and the payout is covered 2.7 times by earnings per share. Real-estate investment trust Primary Health Properties currently yields 5%, and the payout is covered one-and-a-half times by earnings per share. The company’s highly defensive nature more than makes up for its low payout cover.

Of course, how you decide to build your ISA portfolio is entirely up to you. And, if you don't find this advice useful then there are plenty of other ways to build an income portfolio that won't let you down. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.