Investing Basics: How to spot an income stock
Several Australian companies again paid record dividends in fiscal 2018, but what are these dividends, where do they come from, and how do you find more of them?
Many investors keep a close watch on company dividends, particularly retirees or those who are about to retire and who need a steady, reliable income stream.
But how do you identify good income stocks? A company’s dividend yield is a common starting point, but it doesn't tell the whole story.
What is a dividend?
A dividend is a distribution of a portion of the profits generated in any given year by a company or managed fund.
For Australian companies, they are most commonly paid twice annually – at the end of the first-half and full financial year – but may also be paid quarterly. Dividend details, including whether there will be one, how much, the format in which they'll be paid, and when is typically announced during company financial reporting.
Infrastructure companies are often favoured as sources of dividends
By law this information must be provided to the Australian Securities Exchange, because it has very real - or “financially material” - implications for companies and their shareholders, as explained below.
But not all companies pay dividends. Companies at different points in their lifecycles, of various sizes (market capitalisations), and various sectors are more inclined to pay dividends than others.
"If you're looking for companies that are going to have reliable dividends,” says Steve Bruce, an Australian equities and income fund portfolio manager at Perennial, “typically you're looking for a company that's been around for a while, with a long track record, and that isn't a start-up, that isn't all about blue-sky upside.
"It's typically your well-established, more stable larger types of company".
Who pays dividends?
Over time, a more mature, successful organisation is more likely to generate excess revenue, beyond that needed for its day-to-day operations.
Companies sometimes pay dividends because they can’t find enough promising projects to invest in for future growth, so they return a higher proportion of profits to shareholders.
Smaller, newer companies are less likely to have excess capital, with more on of their revenue used to fund ongoing operations and expansion efforts. As such, they don't usually pay a dividend yield.
Sectors that are generally more likely to yield income include: utilities, basic materials (commodities) and financial sectors. But this isn't always the case.
"We would argue that it's just as important to pay attention to diversification [for income investors] as it is in any other portfolio of stocks," says Bruce.
"In theory, [regulated utilities] are stable, but the fact they're regulated entities does expose them to regulatory risk, by their very definition".
Similarly, infrastructure stocks, such as Transurban (ASX: TCL) and Sydney Airport (ASX: SYD), have been very popular income-yielding stocks, because they're deemed to be very defensive, Bruce says. However, it’s important to note, he adds, that they are “extremely sensitive” to interest rate movements.
Sector-specifics aside, excess corporate cash can either be reinvested in the company (capital expenditure, or cap ex) or paid to shareholders as a dividend or some other form of capital return, such as a share buyback.
What is dividend yield?
Dividend yield has long been considered a key measure of company valuation. It is a comparative measure of company's past-year income distributions divided by its current public offering price, expressed as a percentage.
The dividend yield is equal to a company’s annual dividend per share, divided by its stock price per share.
So, if a company pays an annual dividend of $2 and has a stock that trades for $100, its dividend yield is 2 per cent. If that same stock’s price fell to $50 per share, its dividend yield would rise to 4 per cent.
The reverse also applies – as the stock price rises, the dividend yield declines.
"It isn't the be-all and end-all,” Bruce says. “You want a balance between a company which can pay a reasonable level of dividends and grow earnings over time … because as those company earnings grow, a dividend stream should grow as well.
"There's no point buying a company just because it has a really high dividend yield this year, if it's earnings are just going to go backwards next year and the year after, because in all probability, the dividends will go backwards as well, and the share price will go down."
Financial planner Ian Bailey, co-founder of Bailey Roberts Group, agrees. "Yes, we take it into consideration, we add it into the equation for measuring the intrinsic value of the stock, but to me, it's more important to buy something of value than purely based on dividend yield."
"If you lose 5 per cent in dividends, that's something, but if you lose 50 per cent of the stock value, that has a far greater impact than your dividend being reduced … it's important to have a broader understanding of the business that you're buying into," Bailey says.
For example, Telstra's (ASX: TLS) dividend yield, excluding any special dividends, peaked at 9.69 per cent in 2011, before falling away in successive years down to less than 5 per cent in 2015. Since then, the yield has trended back up to 8.4 per cent for the year ending 30 June 2018.
As Perennial's Bruce says: "You'd rather invest in companies where the dividend is slightly lower, but where the dividend per share, for example, can be expected to grow over the coming years; rather than having a share that might have a high yield this year, but where there's no growth – or negative growth – in the future.”
Getting the balance right is crucial, Bruce says: "You should never buy a company just because it pays a high level of dividend; you have to like the other fundamentals as well, the growth that it can provide, and the balance sheet that it all sits on top of.”
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Glenn Freeman is a senior editor at Morningstar, based in Sydney.
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