Dividend investing sounds easy. Simply invest in a high dividend stock, sit back and count your cash, right? Not so fast. Like any investment strategy, it has its intricacies, and is not as simple as it sounds. Just ask shareholders of Provident Financial, which cut its dividend recently and saw its share price plummet from 1,750p to 600p in the blink of an eye. Here’s a look at three mistakes you may be making as a dividend investor.
Investing in ‘dangerous’ high-yield stocks
The first mistake that many dividend investors make is that they get greedy. They assume that a stock yielding 7% is a better investment than a stock yielding 4%, when in reality that’s not always the case.
You see, when a company has an extremely high yield, it’s often a sign that the market is anticipating a dividend cut. What’s happened is that many investors have already sold the stock, pushing the share price down, and as a result, the dividend yield has increased to a level that looks really attractive. If the company does cut its dividend, often the stock will fall even further, and you’ll be left with a sizeable capital loss, and a lower dividend yield.
I’ve made this mistake in the past myself, buying J Sainsbury shares when the yield was above 6%. The company cut its dividend by 24%, and the share price fell from 320p to 230p. Lesson learnt.
Therefore, in my opinion, you’re much better off picking out dividend stocks that yield between 3%-5%, instead of going for the highest yielding stocks in the index. Remember: “if it looks too good to be true, it probably is.”
You haven’t assessed dividend sustainability
Given that dividend cuts can result in wealth-destroying capital losses, you want to avoid them at all costs. That means it’s important to examine whether a company can actually afford to pay its dividend. The simplest way to do this? The dividend coverage ratio – which measures how comfortably a company can cover its dividend payout with its profits. The ratio is calculated by dividing the company’s earnings per share by its dividend per share, and the general rule of thumb is that a coverage ratio of two or more is healthy, while a ratio of less than 1.5 is risky.
Another useful ratio is the cash dividend payout ratio, which measures the proportion of the company’s cash flow that it pays to ordinary shareholders, after subtracting preferred dividend payments.
The ratio is calculated as: common stock dividends, divided by cash flow from operations minus capital expenditures and preferred dividends.
Given that a company requires cash to pay a dividend, this ratio is worth checking. A ratio higher than 100% indicates the company is paying out more in dividends than it is receiving in cash, which is not sustainable in the long run.
You haven’t looked at the dividend growth
Lastly, it’s always worth examining a company’s dividend growth history and the growth projections for the future.
The best dividend companies are those that increase their dividend payouts on a consistent basis. Not only will you receive an increasing stream of income, but over time, as the payout rises, you’ll most likely find that the share price rises as well, as investors are willing to pay more for the higher yield.
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Edward Sheldon has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.