Some of the most profitable stocks over a long period of time have been big, strong, and fundamentally sound companies that pay big healthy dividends. Newer investors who want to dip their toes into the market will often first gravitate toward stocks that give back profits to the shareholders as this can reduce some of the risk of ownership. Older investors love the long term profitability with income generation.
As new and seasoned investors alike turn to dividend paying stocks, we should definitely give it some serious consideration. The process is not nearly as simple as grabbing the highest paying dividend stock and then forgetting about it.
To begin we need two goals for investing in dividend paying stocks: saving and earning.
Preserving Capital and Making Income
If a friend guaranteed to give you 5 percent annual return on your investment would you go for it? What if he guaranteed the return, but the capital would be used in slot machines – would you still be so quick to hand the money over? So it goes with investing in high dividend stocks, we want to feel secure that as we hand our money over the capital has relative safety, or at least a low risk of bankruptcy. Part of the reason many people use banks as opposed to their top drawer is the ‘safety factor’. So too, the stocks we pick should be more like a safe than a sock drawer.
Our second goal once we have established ourselves with a sound company is to look for a steady flow of income. If we are just starting out with investing we will likely be re-investing the dividends. If we are in retirement we are possibly using the dividends as supplemental income. We want as high yield as possible. Does that mean that we can open any stock screener and quickly find the highest paying dividends to invest in? That could create a problem
There is More Than Yield to Consider
A stock with an abnormally high yield might seem like an easy play. But often, things that seem too good to be true are. If a yield is abnormally high, we might need to consider:
- What type of stock is it? Some stock categories get higher yields than others.
- Why is the yield so high? Is this stock in danger? Is paying out such a high dividend sustainable or is this a one-time event?
- Has the stock plummeted recently giving it a high yield in proportion to the share price?
You see, just because a stock has paid out high dividends in the past in not a guarantee that they will continue to do so. If the share price plummets and the company is in danger, they may decide to preserve their own capital by paying off debt or re-investing it themselves instead of divvying it up between shareholders. Let’s consider some of the other areas that we need to consider when it comes to high yield dividend stocks.
High Yield Dividend Stocks and Franking Credits
Do you like paying tax? How about being double-taxed? If you live in Australia you have the advantage over many other countries in that you can get around being double taxed. For this we thank our friend Frank.
When the company earns profit it pays tax. In many countries when you get the dividend from the profit sharing, you pay tax on it. The government may receive up to 70 percent tax. How do franking credits help prevent this?
A fully franked stock will lower your taxation rate by the amount the company already paid. For instance, imagine the dividend was to be 100 dollars. The company paid 30 dollars in tax thereby giving you 70 dollars in dividends. Your taxation rate is 40 percent. So the calculation goes this way: Pretax dividend is 100 dollars. Your taxation rate is 40 percent. You owe 40 dollars. Company already paid 30 percent thereby leaving you with 10 dollars or 10 percent to still pay.
A few things to keep in mind:
- If your taxation rate is lower than the company’s rate, you will get a tax refund
- Dividends can be partially franked or fully franked or grossed up meaning not franked at all
Of course 100% franked dividends are the easiest to calculate and the best. But if you want to compare apples to apples, find a franking or dividend imputation calculator. Realistically the calculations are not that difficult. Please read our "Dividend Imputation System & Franking Credits Explained" article for more on franking credits and calculations.
Dividends in Cash or Shares
Instead of cash, companies may also provide the profit sharing in the form of more shares. This is known as a Dividend Reinvestment Plan or a DRP.
DRP’s can be beneficial for a few reasons:
- Forced savings plan
- Reinvesting profits instead of spending it
- Sometimes shares are offered at a discount
- Compound interest effect
You must remember that even though the company may reinvest the shares for you, you still must pay taxes on this income. After all, the shares do have value.
The one drawback to DRP’s is if share prices rise sharply. Your reinvested profits would be going into an overvalued share price. If the share price at time of reinvestment is fairly valued, this can be a very good program to build a portfolio with.
Stocks with High Dividends
I mentioned earlier that certain stocks have higher dividends than others. What types of stocks would these be?
The Australian Banks have been nothing short of amazing for the past decades. Finding a fairly priced stock (one that is not overvalued), with a fully franked dividend of 4 to 6 percent makes for a good investment.
- Listed Investment Companies
These are funds dressed up as a company. Some have found that the LIC’s offer a much smoother way to invest than property trusts. As property goes up and down the dividends may vary whereas the LIC’s accumulate income and capital gains. Two revenue sources are better than one.
One area to be on the alert for: look to the net tangible asset value after taxes (NTA) to know if it is fairly valued or not. Do not purchase overpriced LIC’s.
- Property Trusts
These trust funds typically payout 6 to 10 percent per year. The fund may be a blend of apartments, retail, hotel and so forth. A good rule of thumb is to buy these when interest rates are low since they offer a good alternative to what banks offer. When interest rates rise, these often seem far less attractive in the eye of the average investor.
As well, to lower risk choose property trusts that perform well in bad markets. These often include trusts based on lower income housing such as apartments. High end flats or expensive commercial properties may not perform well in down markets.
- Other High Yielding Stocks
Utility companies, retail businesses, and property developers are included in the high yielding stock category. Of course, it is assumed that you will perform due diligence to ensure the company share price has not fallen making the dividend look artificially high.
Now that you have a good idea what to look for in a dividend stock, you can access certain websites to find out more about the company and the dividend it pays out. Here are example of quality stocks with high dividends with potential of growth JB Hi-Fi (JBH), CBA, TLS, WOW, MAP (MAP Group), STO, Servcorp (SRV), and QBE.*
Purchasing stable stocks and other investments that provide dividends is a great way to gain an extra income or compound profits for new and more experienced investors alike.
*Stocks on the ASX for 2010