Three steps to finding high yielding, good value shares

Volatile markets, low interest rates and above-target inflation constitute a worrying mix for investors. In times like these, large, well-established companies which pay generous dividends are becoming increasingly attractive - but how can investors identify these shares?

Restricting the search to the FTSE 100 could prove a good starting point, as for the most part these companies are well-established, have strong cash balances and are highly cash generative. This makes them more resilient to economic crises and more likely to maintain their dividends than smaller businesses.

Beware the value trap

The FTSE 100 is full of companies paying a decent dividend yield, but choosing companies on this basis alone can lead to a 'value trap'.

Dividend yields are backward looking, calculated by dividing last year's dividend by the current share price. A company which paid dividends of 4p a share last year, with shares currently trading at 100p each, would show a yield of 4%. If the company issues a profits warning, and the share price falls 90%, it still paid a 4p dividend last year so the yield becomes 40%.

However, the trading difficulties responsible for the share price decline are highly likely to impact the company's ability to maintain its dividend, which will almost certainly be cut, so while the yield says '40%' investors expecting another 4p dividend are likely to be severely disappointed.

To attempt to avoid such pitfalls, and further narrow the field, many investors use the ratios described below.

Can the company afford these dividends?

When searching for high yielding shares, investors should look for companies able to maintain, or preferably grow, their dividend. One method used by investors to judge this is to look at the company's 'dividend cover' - the number of times a company's dividend is covered by its profits.

For example, if a company makes £100 million profit and pays out £50 million in dividends, its dividend cover is 2. A dividend cover less than 1 means the company is paying the dividend out of previous profits (the company's cash balances) - unless future profits increase, it's unlikely the dividend will be maintained at these levels for long. Nevertheless, while a well-covered dividend offers reassurance, there are no guarantees. BP's dividend was well covered prior to the Gulf of Mexico disaster, yet it was forced to stop paying dividends altogether for two quarters.

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Are the shares good value?

It's important to consider whether the shares are the right price. One simple way of assessing the value offered by a share is the price/earnings ratio (PE). It is calculated by dividing the share price by the earnings per share, for example if earnings per share are 20p and the share price is £1, the PE ratio is 5.

The PE ratio shows how much investors are willing to pay for £1 of the company's annual earnings. A company with a low PE ratio is said to be 'cheaper' than one with a higher PE ratio - £1 of current annual earnings can be bought more cheaply.

However, looking at the PE ratio in isolation also risks a value trap - a company's shares might be cheap because of underlying problems which mean future earnings are likely to fall. Likewise, a company's shares might look expensive because the market is factoring in future earnings growth.

Another method is to look at a company's forecast PE ratio. This uses an analyst-estimated value for a company's next year's earnings per share and could help identify any expected change in earnings when determining a company's value.

So which shares to choose?

I have applied three filters to the FTSE 100 to identify seven shares which I believe could be worth a closer look.

The table below shows companies with a dividend yield of more than 4.5%, dividend cover greater than 2, and both current and forecast PE ratios lower than 10. They could make a good starting point for your own research. Please remember past performance is not an indication of future performance.

Source: Digital Look 28 June 2012

Free guide - How to select shares

The method described above is just one of the many techniques an investor can use to identify shares with potential. If you're interested in learning how to choose shares for your portfolio our new guide: How to select shares contains six common-sense strategies, used by successful investors plus a brief guide to fundamental and technical analysis.

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A word on risk

Purchasing individual shares is intrinsically risky, as the value of an investment is linked to the fortunes of one company (though of course some companies are riskier than others). If the company goes bust, shareholders can lose their entire investment. For this reason many investors choose to invest in shares through funds, which spread the risk over a number of companies. Equity income funds aim to invest in the type of company highlighted above - to view details of our favourites, please consult the Wealth 150, our list of favourite funds across all the major sectors.