Investors scanning the markets for the best income generating opportunities tend to alight on bonds and equities. You can read about investing in bonds in our guide on that subject. In this guide, we'll be looking at what you need to consider when shopping for dividend paying shares.
Buying shares is not risk-free - nothing is - but pick the right companies and they can provide a steady stream of respectable income for years on end. There's also the additional prospect of capital growth thrown in.
In this guide we'll tell you where to find them - you may need to travel for the biggest returns - and what to look for - everything is not always what it seems. We point out the potential pitfalls, too, and tell you how to avoid them.
Surely, the highest yield is best?
There are some extremely high yielding stocks around, but don't be greedy. Headline-grabbing yields carry an obvious health warning and tend to scream "distress". Just a little digging normally uncovers a plunging share price, which flatters the historical yield. Find out why. Has there been a profits warning, or cut in the dividend? Is the company even paying a dividend anymore?
As a rule, risk tends to increase with the yield, and a company offering much above 6 per cent should cause alarm bells to ring. According to research, seven out of ten companies on a forecast yield of 7-8 per cent actually cut the dividend. Above 10 per cent, and it's nine out of ten. Doing your homework is crucial.
What, then, is the "right" equity dividend yield? Most fund managers are more than happy with 4-5 per cent where there is much lower risk of a dividend default.
The dividend yield trap
Working out the dividend yield is simple - annual dividend divided by share price multiplied by 100. The one variable on a daily basis is price. Clearly, if the price of a share falls, the yield improves and vice versa.
That's why attempting to pick a stock for income based purely on a quick glance at the financial press or investment websites could lose you money. Yields commonly quoted are nearly always historic, the so-called trailing yield. That means they reflect the last interim and final dividends paid, not necessarily the dividends you will receive in future.
For a more accurate idea of what you could receive if you buy the shares now, the forecast yield, based on what the well-informed analysts think the company will pay in the year ahead, is much more useful. Of course, much of the time they will assume the company in question does continue to pay a dividend. That's why it's best to use this method for the larger, well researched blue chip companies with balance sheets more able to absorb short-term financial shocks. The City is quite good at spotting the warning signs, too, and will be quick to flag up any problems.