The Motley Fool

Rio Tinto plc And Royal Dutch Shell plc: When Is A Dividend Yield Too High?

Income investing is the cornerstone of many people’s portfolios. Buy into a company with a reliable dividend yield, and you can accumulate and reinvest those dividend cheques. It’s the ideal way to grow your wealth.

But which companies should you buy into? Well many investors think that you should look to mining and oil companies such as Rio Tinto (LSE: RIO) and Royal Dutch Shell (LSE: RDSB). After all, these are firms with a track record of cash-generation, with juicy dividend yields.

Are the numbers deceptive?

Check the numbers and they certainly seem tempting. Rio Tinto’s current yield is 7.95%. Shell’s yield is 8.12%. Wow, you say. Even if the share price stays where it is, the dividends alone will provide a very healthy return.

But let’s dig a little deeper. What about earnings? Well, this is where things start to fall down. Because the backdrop of tumbling metal, mineral and oil prices means that profitability for both of these companies is sliding.

The P/E ratio for Rio Tinto is 23.58. Shell actually made a loss last year. In 2016 it’s predicted to have a P/E of 32.72. That looks expensive. The commodities boom of the past decade has meant massive investment in new mines and oil wells. This has led to oversupply, so the prices of iron ore and Brent crude have been trending downwards. Cue falling earnings.

So if earnings are falling, why on earth is the trailing dividend yield so high? That’s because this represents profits from previous years. So they always tend to lag the share price. The share price falls, but dividends are still high so the yield rockets. But this is a temporary phenomenon. These numbers are really just a snapshot.

I expect dividends in the future to be cut, and cut substantially, because profits over the next few years simply won’t cover the payouts at their current level.

Dividend investors should look elsewhere

There are other concerns too. A picture of falling profitability means that the share price is also likely to fall. Not only will you receive less income, the value of the shares you own also falls. So you lose in both ways. Suddenly, these companies don’t look so appealing.

What investors should look for isn’t the highest yield they can find. They should seek out consistency, both in terms of dividend payouts and company profitability. If these are rising steadily each year, then you should buy-in.

The only light at the end of the tunnel is if mineral and oil prices were to recover dramatically, and soon. It could happen, but my balanced view is that commodity prices will remain low for the next decade. This doesn’t bode well for income investors who want to buy into resources.

So my advice on Rio Tinto and Royal Dutch Shell remains unchanged. These companies are to be avoided.

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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has recommended Rio Tinto and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.