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How to screen for promising dividend shares

Once you have established a solid foundation of dividend knowledge and understood the differences between the various types of dividend shares, you are ready to start prospecting for potential income investments.

Today I’ll discuss how you can get started in the dividend research process.

Panning for golden ideas

Poring over each of the 600-plus companies listed in the FTSE All-Share index to identify a few promising ideas is an arduous and time-consuming task.

Fortunately it’s a task that’s been rendered unnecessary by one of the most glorious by-products of the Internet: the share screener tool.

The primary purpose of a share screener is to reduce the vast number of potential portfolio candidates to a handful of names that you can research further.

You simply enter a few key parameters and the screener displays the select companies that fit your chosen attributes.

One important point to make right away is that screener results should not be considered automatic buy lists. Further research is always necessary, as screener results don’t always tell the whole story. (In the next two articles, we’ll discuss this process for researching individual shares.)

A number of helpful screening tools are available to UK investors online, including:

Free screeners:

Premium screeners (i.e. not-free)

If you’re just starting out, the free screeners will do the trick. More experienced investors may want to try the premium screeners, but for our purposes here we’ll just use the free screening tool from The Telegraph.

How to screen for high yield shares

In the previous article in this series, we defined ‘high-yield’ shares as shares with dividend yields between 1.2x and 2x the market average.

With the FTSE All-Share average yield currently near 3.6%, we can begin screening for high yield shares by entering 4.2% to 7.2% into the ‘dividend yield’ parameter about two-thirds down the screener page.

If you try this dividend yield range in a share screener tool, however, you’ll find that you get a list of several dozen companies in the results. For a more manageable hit list of potential high yield investments, we’ll need to enter a few more parameters into the screener to further narrow our search.

With high-yield shares, dividend sustainability is more important than growth potential — a high yield does us little good if the payout gets cut in the subsequent year — so the extra parameters will be designed to help us identify companies with the ability to maintain their current dividend and ideally grow it each year.

To identify high-yield shares that are likely to maintain their payouts in the coming years, we can enter the following five parameters:

  • Index: FTSE All-Share. Whilst there may be good opportunities among AIM-listed shares, most investors will want to hold their dividend shares within the tax shelter of an ISA. They’ll therefore need to own LSE-listed shares and to avoid AIM-listed shares.
  • Return on equity > 10%. Companies that are unable to consistently generate returns on equity above 10% are likely destroying shareholder value. Even though high-yield companies aren’t usually high growth companies, we nevertheless want to own shares that are at least earning their cost of equity each year. Searching for companies that generate at least 10% return on equity is a fair place to start.
  • Dividend cover > 1.2 times. The Telegraph share screener tool does not have free cash flow cover, but the earnings-based dividend cover will do for now. (We’ll discuss calculating free cash flow cover in the next article.) Another way to think about this metric is that a company with 1.2x dividend cover is paying out 83% of its earnings as dividends (1/1.2). This is the absolute minimum amount of dividend cover that investors should demand when researching high-yield shares, in my opinion. Without the ‘margin of safety’ afforded by a well-covered dividend, a year or two of lower earnings could force the company to reevaluate its dividend policy.
  • Five year turnover growth > 0%. Sales are the life-blood of the financial statements, so companies with declining turnover may be steadily shrinking. Companies in a state of secular decline usually feel pressure to take drastic actions to maintain profitability, such as a large merger or massive restructuring plan. Those situations can be messy and all else being equal we want to avoid getting entangled in them, because dividends can come under the chopping block in an effort to boost cash flows.
  • Five year EPS growth > 3%. Similarly, we also want to see at least a little growth in earnings per share. A situation where a company’s EPS is contracting whilst dividends per share are growing is simply unsustainable. Eventually the dividend will come under pressure. Because we want our high-yield shares to grow at least modestly in the coming years, we want to see a recent track record of positive EPS growth.

By adding these five parameters, we get a much more manageable list of shares to research:

High yield screen as of October 17, 2012 (Click to enlarge)

Though we still have some work to do — particularly on valuation — the screen has helped us identify some promising high-yield research candidates. My next article in this series will discuss how to further research high-yield shares once you’ve found them via a screen.

Screening for dividend growth shares

To screen for ‘dividend growth’ shares that may have lower starting yields but have more potential to grow future payouts at high rates, we simply need to make a few adjustments to our screening parameters.

Since we’ve previously defined dividend growth as shares between 2% and 1.2 times the market average, we’ll change the dividend yield range to 2% to 4.3%.

We’ll again stick with just FTSE All-Share stocks in this screen to make sure they are ISA-eligible.

Here are a few more settings:

  • Return on equity > 15%. Companies that consistently generate returns on equity over 15% likely have some type of sustainable competitive advantage. Otherwise, you would expect competitive forces to drive ROE downward to the company’s cost of equity. Although ROE does have some flaws (which we’ll discuss in the next article), screening for companies with ROEs over 15% give us a better chance of finding shares with the ability to produce high rates of return.
  • Dividend cover > 1.5 times. When looking for dividend growth ideas, we should demand more dividend cover than in the case of high-yield shares for two reasons. First, because we want to identify firms with higher growth rates than high-yield shares, we naturally want these companies to retain a meaningful amount of profit each year to reinvest in the business to promote sustainable longer-term growth. Second, by starting with a higher dividend cover ratio, we’re giving dividend growth shares the potential to grow into a lower dividend cover as they mature. A dividend growth share that’s consistently paying out 90% of earnings today, for instance, doesn’t have much room to augment its payout ratio as growth slows and is thus primarily dependent on earnings growth to deliver dividend growth.
  • Five year dividend per share growth > 7%. Just because a company may have the financial strength to increase its dividend at a high rate, it doesn’t mean that the company’s board will do so. For instance, the board could prefer to employ share repurchases or engage in aggressive M&A rather than pay out free cash as dividends. By identifying shares with a track record of raising dividends, we stand a better chance of avoiding companies not fully committed to their dividend programmes.
  • Five year EPS growth > 7%. Whilst companies can artificially boost earnings per share using buybacks, most corporate boards of directors use EPS-based payout ratios when determining dividend policy. If the board is seeing strong EPS growth, then they’re more likely to boost the dividend at a similar pace.

As of 17 October. (Click to enlarge)

As you can see, we have plenty of good ideas to research and from a variety of sectors, too, including financials, commodities, consumer goods, and technology.

We’ll take a closer look at this list of dividend growth ideas after we discuss high yield shares in the next article.

Still more to do

Share screening tools have greatly simplified what was once a time-consuming task of idea-generation. Nevertheless, a successful screen is just one part of a complete research process.

Over the course of the next two articles, we’ll discuss how to use screener results to select the best of the best ideas.

In the meantime, why not try your hand at a few screens and see how they can work for you? And if you have any of your own screening tips, please share them in the comments box below!

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{ 9 comments… add one }
  • 1 Miserly Investor October 25, 2012, 11:58 am

    A good, practical article on how to screen for dividend shares.

    As you say, the key thing is to view this as “idea generation” only, as the basis for proper research using primary sources as annual reports and results announcements. Often the databases are riddled with errors and should not be relied on for accuracy!

    Over the years I have also learned not to filter too tightly as for whatever reason we can easily filter out perfectly good candidates. So never stick to one particular screen.

    Another important screening criteria is market cap for those investors wishing to stick to large and mid caps – that will shorten the list somewhat.

    Liking the dividend investing series,
    MI

  • 2 W at Off-Road Finance October 25, 2012, 9:33 pm

    I like your screens – especially the focus you put on the sustainability of dividends. Too many people find some 7% dividend stock, buy it, and then feel like they got unlucky when the dividend gets cut in half 3 months later.

  • 3 Rob October 25, 2012, 10:27 pm

    The two biggest dividend disasters in recent years have been BP and the banking sector.
    No amount of historic research would have forewarned anyone of these catastrophes.

    Analysis of financial history is fascinating, but it is just that. It tells you nothing about what will happen next.

  • 4 The Analyst October 26, 2012, 2:11 pm

    @MiserlyInvestor: Cheers! Yes, it is important to not filter too tightly as there can often be valuable ideas that fall outside the parameters of any given screen.

    @W at Off-Road Finance: I agree — sustainability is the key when it comes to high-yielding shares. It’s critical not to chase yield!

    @Rob: Absolutely. A screen is just a starting point, of course, and further research is always required to develop a better understanding of what’s behind a company’s operations. Unforeseen circumstances are a part of investing — and, in fact, sometimes they’re good circumstances! — and that’s why it’s important to stay diversified and have a firm understanding of the businesses you own. You don’t need to be an expert, per se, but at least be able to explain to a friend how the company makes money.

  • 5 Rob October 26, 2012, 10:17 pm

    It is not hard to find shares that yield more than the market. The question is what do you want this portfolio to do? It ought to give you a higher income than the market average but it is unlikely to give you the same total return as the market.

    Selecting a subset of the market to increase income will also increase risk. At some point that risk will be crystallised as a lower return.
    That is the reason equity income funds don’t work.

  • 6 The Investor October 27, 2012, 12:35 am

    @Rob — Nobody can say this website does not give passive investing a fair crack of the whip, but these articles are for those who want to actively invest in a dividend seeking strategy, for whatever reason they might have. I’m not interested in the comments becoming off-topic battlegrounds and will moderate further comments accordingly. Thanks.

  • 7 Moneyman October 28, 2012, 11:13 am

    Great set of resources.

    Are any of the criteria based on backtested research – or just your alpha? (Not that I disagree, generally)

    A high-yield dividend portfolio can be quite volatile: I have now migrated to 50%/50% dividends/fixed-income – in fact the fixed-income portion has had a higher yield and lower capital losses (in fact no loss, compared to several disappointing dividend shares).

  • 8 The Analyst October 30, 2012, 2:03 pm

    @Moneyman: Cheers! The screening criteria aren’t designed to be part of a buy/sell algorithm, so backtesting for alpha isn’t necessarily all that important, in my opinion. If we were designing a formula that would tell us to buy this share or sell this share based on a set of metrics, etc. then I think backtesting would be warranted. For our purposes here, we’re just trying to narrow down the vast number of available shares to a digestible group for further research.

  • 9 Aron February 6, 2014, 9:43 pm

    Maybe a silly question, but when using either Digital Look or the Telegraph screener they seem to come up with different companies even with the same criteria listed. Or is it best to try out a ‘premium’ one?

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