Buying dividend-bearing stocks is a great way to build a retirement portfolio. Companies that pay dividends tend to be larger, more mature and less subject to wild stock price fluctuations. This is not universally the case though. Just look at the energy sector in recent months. Even the biggest oil majors like Royal Dutch Shell have declined in price significantly, with the coronavirus market crash adding to the pain.
That said, a lot of dividend-paying companies are in cyclical sectors (like energy). This means that even if the industry has a down period, you can be reasonably sure it will turn around at some point in the future. Here are two tips that I think all FTSE 100 income investors should know.
It’s not just about the yield
It’s a common misconception among novice income investors that the most important factor is dividend yield. After all, the higher the yield, the more money you will receive, right? Not necessarily. The yield that you will see quoted if you research your chosen company is based on the dividend that has been forecast by the business in its latest trading update. The yield is a measure of how big the dividend is relative to the share price.
You could easily have a situation where the share price tanks as a result of some unforeseen event, but management has not yet updated its dividend to reflect the new market conditions. In this case, the yield would be high, but it would not be an accurate reflection of reality. For this reason, you must always closely scrutinise a company’s financial statements to figure out whether it is likely to fulfil its promises. Of course, if the business hits a rough patch and its yield spikes, but it has a large cash buffer, there is a decent chance it is still a good value buy. But do remember that a high yield can be a danger sign suggesting a company is on shaky ground. If a generous yield seems too good to be true, it often is. In that case, you should do more research.
Pay attention to total return
A company that returns a lot of cash to its shareholders through dividends is not necessarily doing right by them in the long run. Many investors buy shares for dividend income. But dividends should not be paid out if it harms the company. That could mean taking on debt to pay dividends. Or it could mean neglecting investment to pay them. Some money should only be returned to investors if there is no way to put it back into the business, as the latter is more tax-efficient than paying dividends. For this reason, a company with a 5% yield might be a better investment than an equivalent company with an 8% yield. If the former is putting its cash flow to better use by expanding the business or even building up reserves of cash as a buffer against unexpected events, that is a sign of careful management.
Income investing is about getting dividends, yes, it is also about picking businesses that will give you a decent total return (income from dividends plus capital appreciation) for the long term. So never lose sight of the bigger picture when looking for great income stocks.
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Neither Stepan nor The Motley Fool UK have a 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.