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Picking your first income stock

Do you know the only thing that gives me pleasure? It's to see my dividends coming in. - J.D Rockefeller

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Dividends are one of the main attractions of investing in the UK stock market over the long term.

Those that have reinvested dividends instead of just banking the payout have traditionally seen much higher returns, although of course this isn’t guaranteed. But what does a “good” dividend look like? There are plenty of things to consider, like not getting hung up on historic yields, and making sure a company can afford its shareholder returns, to name just a couple.

Here we explore the potential power of dividends, as well as key considerations to help you pick your first income stock.

Take a look at the graph below. It shows the difference reinvesting your dividends can make. Two £1,000 investments in 1985 in the FTSE 100, have grown to quite different values today – one reinvested dividends and the other shows the impact of taking the dividends as cash.

Value of £1,000 invested in the FTSE 100

Past performance is not a guide to future returns. Source: Lipper IM 02/10/2019

There are a few ways to find income. Investing in equity income funds or a passive tracker fund could provide a source of income, but there are reasons you might want to invest directly in a company if you are happy with the risks. You won’t incur fund management fees, which boosts potential returns, and you can also seek out potentially higher dividend yields.

However, investing directly in shares requires more effort from individual investors. Not only do you have to find a company that’s currently paying a healthy dividend but make sure it’s able to maintain, or preferably, grow the dividend over time.

So how do you pick the best income shares? Here are three things to think about.

Yields are variable and not a reliable indicator of what you might get in the future. The value of all investments and income can rise and fall so you could get back less than you invest.

Don’t get too hung up on the dividend yield

At first glance, lots of companies have good dividend yields. But it’s unwise to invest on this basis alone.

Most dividend yields you find on the internet are backward-looking. That means they’re calculated by dividing last year's dividend by the current share price.

For example, a company that paid a 4p dividend per share last year, with shares currently trading at 100p each, would show a yield of 4%. But if the share price fell 90%, it still paid a 4p dividend last year, so the yield becomes 40%.

However, the reasons for the share price fall are more than likely to impact the company's ability to maintain its dividend - which will almost certainly be cut. And while the yield says '40%', investors expecting another 4p dividend are likely to be disappointed.

When we write research on a company we address this problem by using ‘forward’ or ‘prospective’ yields. These are based on a range of analyst forecasts for next year’s dividend. Unfortunately these are still only estimates, and there’s no guarantee that analysts will get it right or that the current dividend is sustainable.

Can the company afford its dividends?

Dividend cover is a useful sanity check when it comes to assessing if a company can afford its dividend. It summarises the number of times a company's dividend is covered by its profits.

If a company makes £100m profit and pays out £50m in dividends, its dividend cover is 2.

Pinning down total profit and total dividend can be difficult when looking at company accounts, so look for per share numbers instead. All companies report profit on a per share basis, called earnings per share or EPS. Simply divide that by dividends per share and you’ll have the dividend cover.

Dividend cover of less than 1 means the company is paying the dividend out of previous profits. Unless future profits increase, it's unlikely the dividend will be maintained at these levels for long. While every sector, and every company, is different, we generally need a dividend cover of 2 or more before we start to get comfortable that a dividend is secure. But while a well-covered dividend offers reassurance, there are no guarantees, it’s always possible that management decide there are more important priorities.

For those willing to dig a little deeper, ‘cash cover’ is perhaps a better measure of dividend affordability. Here you divide free cash flow per share by dividend per share. Again the higher the number the better, but free cash flow per share isn’t an easily available number for those unfamiliar with company statements.

Are the shares good value?

Whether you’re interested in income or growth it's important to make sure the shares you buy are good value. But we’re not talking about the pounds and pence price of the shares. Counterintuitively shares costing £1 each can be better value than those costing 1p. As investing great Warren Buffet put it:

Price is what you pay, value is what you get

A common way to look at a company’s value is through the price/earnings ratio (P/E).

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

It’s 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 P/E ratio is 5.

But as in any other walk of life, you get what you pay for. By looking at the P/E ratio in isolation you’re at risk of buying into poor companies. In investing circles this is called ‘the value trap’. A company's shares might be cheap because future earnings are expected to fall. Likewise, they might look expensive because future earnings are expected to grow.

To avoid falling into the value trap, try comparing the P/E ratio to that of similar companies. Is the company cheaper or more expensive than rivals? Do you think it should be?

This article is not personal advice. If unsure of a course of action for your circumstances, please seek advice.

Why income is important to all investors

In our latest feature, we look at why equity income can be a core investment for every portfolio.

The case for equity income

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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