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Exploring the different types of dividend shares

Despite what you might hear from the financial media who have been quick to talk about dividend-paying shares as if they were a separate asset class, dividend-paying shares are not a monolith. They don’t trade in lockstep with each other any more than do two shares that use buybacks instead of dividends, or a gilt and non-investment grade bond.

Indeed, a share that trades with a 2% dividend yield probably has very little in common with a share that yields 6%. All else being equal, the two companies are likely at different stages in their growth cycles, have different risk profiles, and different dividend policies.

The simplest way to start classifying dividend-paying shares is to find the market average yield (we’ll use the FTSE All-Share), which is currently 3.5%, and call everything above the average ‘high yield’ and everything under it ‘low yield’.

Yet even that classification can be misleading, though, as there are extremes on both sides to consider, as well.

Four types of dividend shares

I reckon we can use four yield categories to establish a reasonably accurate matrix for understanding the spectrum of dividend-paying shares.

Yield category Dividend yield range Translation
Afterthoughts <2% Likely a company in a growth phase; yields are so low that dividends are likely not a part of your main investing thesis.
Dividend growth 2% to 1.2x market average Likely a company in the mature growth phase; expectation that the share will provide a higher income in 5-10 years.
High yield 1.2-2x market average Likely a company growing near the GDP rate; your expectation is to harvest high levels of current income.
Stratospheric >2x Market Average Likely a company in decline or in financial trouble; higher risk of dividend cuts.

Yield ranges as of 10/10/2012.

These are generalisations, of course, and there are always exceptions, but it’s still helpful to see that dividend yields can usually tell us quite a lot about a share.

Perhaps most importantly, it helps set expectations. You shouldn’t buy a share in the high-yield category, for example, expecting 15% annualised dividend growth. It’s simply not likely.

Avoid the extremes

We can set aside ‘afterthoughts’ for our discussion here. Investors primarily interested in dividend-paying shares for income won’t likely waste their time with such low yields.

To see why, consider the following chart tracking income in three scenarios over a decade:

  • 1% yield growing at 15% annualised
  • 3% yield growing at 9% annualised
  • 5% yield growing at 4% annualised

As you can see, even after a decade of 15% annualised growth – a very high growth rate – the share yielding 1% today will still produce far less than the annual income of the other two yield scenarios. Consequently, the low-yielding ‘afterthoughts’ are just not of interest to dividend-minded investors.

We can also set aside stratospheric yielding shares for now. These are shares yielding more than 8% in today’s market – or roughly twice the average. Such ultra-high yields are a special case unto themselves, and they require a distinct analysis. The alluring high levels of current income the stratospheric yielders appear to offer is likely to be unsustainable in the medium-term, and as such investors should approach them with the utmost caution and not purchase them for yield alone.

Having eliminated the two extremes, we can focus on the sweet spot of the dividend yield spectrum – the ‘dividend growth’ and ‘high yield’ categories.

I believe an investor looking to build a portfolio that generates a sustainable and growing stream of income is best served by focusing on these two categories. You should find plenty of selection here without taking undue risk.

Dividend growth shares

What we’ll generally find with dividend growth shares – which in today’s environment are shares yielding between 2% and 4% – are companies that have passed their high-growth stages but continue to retain a significant percentage of their earnings to reinvest in the businesses.

In this space, dividend cover ratios are usually at least 1.8-2 times.

A few classic dividend growth examples today might include Domino Printing Sciences (DNO), London Stock Exchange (LSE), and Diageo (DGE).

The trick with dividend growth shares is, well, the growth part!

Since you’re forgoing a little jam today in hope of more jam tomorrow, you want to feel confident that there will in fact be more jam in a few years’ time. After all, a share yielding 3% and growing its annual payout below the rate of inflation won’t do an income-seeker much good.

Ideally, you want dividend growth shares to offer at least three percentage points above inflation. With RPI inflation coming in at 2.9% in August, for example, that means you’ll want to target at least 6% annualised dividend growth from shares in this category.

In future posts, we’ll discuss more tools for analysing dividend shares, but one way to get a better idea of a share’s dividend growth potential is to determine the company’s sustainable growth rate (SGR).

To arrive at the SGR, take the five-year average return on equity and multiply it by the most recent retention ratio (1 – dividend payout ratio).

What the SGR is telling you is the maximum rate the company can grow without changing its financial leverage (increasing/decreasing debt, etc.)

For example, if the company’s average return on equity has been 15% and it is retaining 50% of its earnings, the sustainable growth rate is 7.5%.

If you’re researching a share in this category, one of the things you want to ensure is that SGR is above your annualised dividend growth threshold. Certainly there are other factors to consider before making a buying decision, but SGR is an important one.

High yield shares

Investors who prefer their jam today will likely focus on the high-yield area of the market, which as I write ranges from around 4% to 7%.

For a real-life example of such a portfolio, check out The Investor’s demo HYP here on Monevator.

Companies that fall into the high yield category have likely passed their above-average growth days and have now settled into growing more or less at the rate of the broader economy.

Classic high-yield mainstays in today’s market include SSE (SSE), Vodafone (VOD), and AstraZeneca (AZN).

When analysing high yield shares, it’s critical to keep a few things in mind. First and foremost, your focus shouldn’t be so much on growth potential, but sustainability of the dividend. As such, more emphasis should be placed on the strength of balance sheet and free cash flow cover.

To gauge balance sheet strength, I recommend considering the quick ratio ((current assets-inventory)/current liabilities) for short-term liquidity analysis and the interest coverage ratio (EBIT/interest expense) and debt-to-EBITDA ratios for longer-term credit analysis.

A company with a strong balance sheet will typically have a quick ratio above 1 times, interest coverage above 3 times, and debt-to-EBITDA below 2 times. For free cash flow cover, look for at least 1.5 times.

Slight variance around those figures is fine and it’s important to compare these ratios with competitors’ ratios, as well. Most utilities will have debt-to-EBITDA ratios above 2 times and free cash flow cover close to 1, for instance, but that doesn’t mean they all have terrible balance sheets or unsustainable dividends. The regulated nature of some utility operations allows for a little more leverage. In cases like this, focus your attention on shares with the best relative metrics to the industry average.

Second, it’s important to determine how a company entered the high-yield area of the market. Because yield and share price have an inverse relationship, it’s often the case that a high yield share was a dividend growth share whose yield increased as the result of a depressed share price and not a more generous dividend policy. If this is the case, be sure you understand why the market sold off the share.

Third, there tends to be a limited number of ‘quality’ high-yield shares and they tend to be concentrated in just a few sectors. Investors should be careful not to overload their portfolios in just a few shares or sectors to maximise yield. Diversification is always important.

Finally, since high yield shares tend to be slow-growers, management teams at these companies may opt to make silly and large acquisitions in order to jump-start growth. This strategy usually means bad news for shareholders — the company overpays, can’t achieve its synergy goals, etc. — and the dividend could be at risk if the move turns out to be particularly bad. Be extra cautious around companies with the habit of making sizeable acquisitions to fuel growth.

Roll your own dividend investing strategy

One of the nice things about building an income-focused portfolio is that you can mix dividend growth and high yield shares to meet your specific goals.

If you’d like a little more current income, for example, but still have a longer-term time horizon, you might put 70% in high yield shares and 30% in dividend growth shares. The possibilities are endless.

The Analyst owns shares of SSE and AstraZeneca. You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

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{ 15 comments… add one }
  • 1 Richard Beddard October 11, 2012, 10:51 am

    Very interesting chart comparing the income from dividend growth shares and what I would call stalwarts. It surprised me, anyway.

    In trying to reassure myself about future dividends I’d be tempted to look at free cash flow since that will determine whether the company can afford it (and to be honest a dividend investor tells me that’s what he does!).

  • 2 Miserly Investor October 11, 2012, 11:09 am

    Hi Analyst,

    An excellent article summarising the yield range and types of dividend shares.

    I couldn’t agree more with your comment on the need to take great care with dividend sustainability for high yielding shares. I have seen a lot of private investors attracted to yield with very little consideration for the risk surrounding dividend sustainability.

    However, careful stock selection of high yielders can be a very rewarding strategy. There is some good evidence of outperformance from selecting high yielding shares e.g. Dimson etc al, and for example comparison of the FTSE 350 HY vs FTSE 350 LY on a total return basis.

    If we concentrate on buying quality at a good yield then there needs to be very little real dividend growth: bearing in mind the long term real return from shares is little over 5%, then a 4% yielder has to do little more than grow at the same rate as the economy in real terms to achieve a decent result for us.

    But the capital movements should be secondary in one’s mind: capital gains are simply a concomitant of the long term growth in income, provided that the shares were purchased on a reasonable valuation.

    The other thing I would add to the chart showing the time required for the growthier shares to catch up, in practice the income from those high yielders in the earlier years will have been reinvested for further income generation which makes the gap even wider in practice.

    Again, well done on a very interesting article!

  • 3 John Kingham October 11, 2012, 2:26 pm

    Not much I can add to that… really excellent article.

  • 4 The Analyst October 11, 2012, 2:34 pm

    @Richard: Completely agree with you regarding free cash flow. Specifically, I prefer using “free cash flow to equity” without including debt inflows as I want to see that a company is in fact paying dividends using internally-generated cash rather than partially financing them with debt.

    @Miserly Investor: Cheers! Certainly a carefully selected basket of high-yielders can be a rewarding approach and I didn’t mean to disparage that strategy. The biggest risk in high-yield investing is reaching for yield with little attention paid to the underlying fundamentals.

    Whilst I agree with you in principle regarding a primary focus on income, I do think it takes an iron will to take comfort in a 4% yield when a share loses 30% of its value. As you correctly note, however, buying the share at a reasonable valuation will help diminish the chances of permanent loss of capital.

    You make a fair point regarding reinvestment and future income. Of course, much would depend on the share prices at time of reinvestment and the percentage actually reinvested. Rarely are dividends 100% reinvested as commissions, stamp duty, fees, taxes, inability to purchase fractional shares, etc. often prevent full reinvestment.

  • 5 The Analyst October 11, 2012, 2:34 pm

    @John: Cheers!

  • 6 Curious-Sarah October 11, 2012, 6:29 pm

    Hello The Analyst

    First thank you for making your articles available for us to read as you obviously know your onions! It comes across in all your articles so far and as a long-time fan of The Monevator I am glad that you have fitted in so well as I was a bit worried at the start. (Sorry! 🙂 )

    Now my question. If the stock market (all the companies paying dividends from 0% to 10% or whatever the highest company is paying) average a dividend yield of 3.5% (as you write in your article) then how can it be that some can be a good investment if they are paying for example 5% as a dividend yield?

    What I mean is that everyone can see that they are paying more money as a dividend than the average, so if they were a good investment paying 5% then more people should go and buy the shares, which supply and demand would say would put the price up and so the price would come down until they were also paying 3.5%?

    Maybe I am not being very clear here but it seems a but “too good to be true” as they say.

    I’m sure I’m missing something obvious but decided to ask (this is my first comment ever on The Monevator website even though I have been a regular reader so it is an honour really not a criticism honestly! 🙂 )

  • 7 The Analyst October 11, 2012, 7:25 pm

    Hi Curious-Sarah,

    Cheers! I’m fortunate that the Monevator readership has been so welcoming. And thanks for making your first comment on one of my posts. The Investor & Accumulator will most certainly be envious. 🙂

    Excellent questions. You’re absolutely correct that since price and yield have an inverse relationship that, all else being equal, more demand for a given share will reduce its yield — and vice versa.

    Let’s assume that the long-run rate of return for the broad stock market is between 8-9%, as has *historically* been the case and is a fair reference point. Let’s also assume that the long-term expected return for a given share is roughly equal to starting dividend yield + dividend growth (via the Gordon Growth Model).

    Keeping these things in mind, we can begin to see that a yield can be “too good to be true” if the assumed yield + dividend growth sum is well-above 8-9%.

    To illustrate, a share that’s capable of raising its payout by 7% each year over the next 10-years is unlikely to have a 10% yield today. If that were the case, the expected return would be approximately 17% annualised — well-above the long-run return of the share market — and a rational marketplace should buy up the share until its yield was much lower.

    More likely, the share yielding 10% today likely has a poor dividend growth outlook — and likely has negative outlook. The market simply won’t — in normal trading circumstances — offer up the combination of stratospheric yield and (even moderate) long-term dividend growth very often.

    Using this framework, we can also see why a share with 3% long-term growth prospects might be trading with a justified current yield of 5-6%, or, conversely, how a share with 7% long-term growth prospects might be trading with a justified yield between 1-2%.

    Ultimately, a low yield share must have higher growth potential than a high yield share, all else being equal. Otherwise, one of the shares is likely mispriced.

    I hope this helps. I realise it’s all a bit theoretical and murky. Let me know if I can clarify anything.

  • 8 Curious-Sarah October 11, 2012, 8:02 pm

    Hello The Analyst!

    Thank you very much for your very fast reply to my question.

    If I understand you properly (I probably do not!) then you are saying that in a “perfect world” every share would be properly priced according to how much it will grow the dividend, and so the share that is a ‘high yielding share’ of 5% will not be growing its dividend as fast as a share that is a ‘low yielding’ (or a growth dividend share according to your table). So this is why it is not “too good to be true” (because the dividend does not grow as fast).

    So my next question is should I only buy high yield dividend shares if I need more income now and cannot wait ten years (or whatever time as I realise that was just an example in your graph) for a dividend to grow from a normal share that is paying the average of let us say 3.5%?

    Otherwise should I invest in an index tracking ISA that follows the entire market of shares as I suppose it will also grow its 3.5% average dividend yield (with some shares growing more and some shares growing less).

    I understand these are probably obvious questions to someone like yourself! I like the idea of buying these dividend shares as it seems better than just index tracking as you get something for your money! (The dividend payments)

  • 9 Joe's Sustainable Portfolio October 11, 2012, 8:43 pm

    That is really good way to divide dividend shares into four types. Now I think about it, Good Energy Group just decided to pay out interim dividend of 1p, which worked out as 0.7%. And bearing in mind that it is still in growth stage, it pretty much fit the bill.

    Speaking of which, I noticed that there is mention of market average, just how do I find market average?

  • 10 The Analyst October 11, 2012, 10:30 pm

    @Sarah: I think you’re beginning to understand it. 🙂 Definitely not obvious questions. I’m sure other readers are glad you’re asking them.

    Yes, an investor looking to maximise current income would likely focus on higher-yielding shares; however, one problem with just owning high yield shares is that they’re commonly clustered in just a handful of sectors (utilities, big pharma, telecoms, etc.). So if you just owned high yield shares, you’d likely lack a suitable level of portfolio diversification.

    By widening your research to include dividend growth shares, you’ll likely find more opportunities to diversify across sectors. You may sacrifice a little overall portfolio yield by adding a sleeve of lower-yielding shares to the mix, but the diversification (and growth) benefits may outweigh that tiny amount of sacrificed yield.

    Ultimately, the decision is yours, of course. Do as much research as you can and build a portfolio that fits your needs.

    @Joe’s Sustainable Portfolio: You can find the FTSE All-Share average yield in the FT’s Companies & Markets section each day. Some free websites may have it as well.

  • 11 Curious-Sarah October 11, 2012, 11:10 pm

    Hello Again The Analyst!

    It has taken me approximately 20 minutes to get each of my messages on here in order so it may be I seem to be understanding it more than I really do but I think you are right! Thank you for taking the time to answer my questions with such long and detailed answers. It is very good of you.

    I may have more in the future so watch out! 🙂

  • 12 Frugal October 12, 2012, 3:44 pm

    So where does that leave holdings like:

    Vanguard Equity Income, SSDR Dividend aristocrats etc? Are these an efficient way to capture the shares with good growth and payment potential?

  • 13 The Analyst October 12, 2012, 6:31 pm

    @Frugal: Perhaps. You’ll need to decide if those funds’ portfolios suit your needs, objectives, and risk tolerance. For instance, if you don’t want to spend a lot of time researching individual shares, you could do worse than consider one of those funds.

    On the other hand, after sorting through those funds’ portfolio holdings you may find that you don’t agree with the current sector exposures. The UK Dividend Aristocrats, for example, has more than half its portfolio invested in industrials and consumer shares; similarly, the Vanguard Equity Income fund has high weightings in consumer and financial shares.

    By creating your own portfolio of individual shares, you can weight your sectors any way you see fit. Don’t like financials? Don’t buy them, or make them just a small percentage of your portfolio. If you really like energy shares, you can make them a larger percentage. You get the idea.

    From a cost perspective, if you are buying and holding the shares in your bespoke portfolio for at least five years and not trading more than a handful of times per year, I reckon they’ll be pretty close with the funds’ expenses. (This depends, of course, on how much capital you’re investing and how low your trading costs are — another factor to research.)

  • 14 Frugal October 12, 2012, 7:08 pm

    I’ve made the calculated choice of investing in an unloved area (Europe) at at pretty dire time (now!) to buy up the best european companies in terms of their dividend policy….

    http://www.spdrseurope.com/product/fund.seam?ticker=SPYW%20GY#

    I’m in it for the long term so euro or no-euro I think its a gd call. Time will tell…

  • 15 Evan October 25, 2012, 9:05 pm

    The analyst &/or Accumulator,

    I am curious what you think about my criteria for my dividend growth watch list:
    1) Start with the Dividend Champion List (US based index that has stocks that have increased their yield for 25+ Years)
    2) Then find those stocks that are at or below their industry’s P/E
    3) Have a higher Operating Margin than their industry
    4) Yield of 2.0%+
    5) Low book value

    http://www.myjourneytomillions.com/articles/october-2012-dividend-champion-watchlist-update/

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