For me, income investing is about being able to sustainably increase the amount of income that can be received from dividends. It’s too easy to pile money into a bunch of high-yielding stocks, just because they have an attractive dividend yield, but you must question whether this is really the best approach to investing?
With companies cutting their dividends left, right and centre because they became unsustainable as the underlying business struggled there’s clearly a more nuanced and careful approach to investing for income. Yes, higher dividend yields than the average is good, but ideally, you want to see dividend growth too.
Secondly, you want to be able to see a good level of dividend cover, that hasn’t been coming down much in the last few years. A dividend cover of 1.5+ would usually provide enough safety for high yielding shares, provided the stock market doesn’t significantly worsen, and you’d expect higher growth shares with lower yields to have a greater level of dividend cover. They reinvest more in growth and pay out less by way of dividends to shareholders.
My basic rules for income investing
- Make sure the company is growing the dividend year-on-year. It doesn’t need to be rising by much necessarily, you just don’t want to see it stagnant, as that indicates a lack of confidence in the business.
- Make sure the dividend cover is greater than 1.5. This can be calculated by taking a company’s earnings per share (EPS) and dividing it by the dividend per share (DPS).
- Make sure that dividend cover isn’t coming down as this could be a sign that the dividend is coming under pressure and may not be sustainable.
- Make sure the company actually pays a dividend. I avoid loss-making companies, for example, because they can’t pay dividends (usually!). I tend to want to see a dividend yield above 4% – but that’s quite arbitrary. Yields slightly lower than this are fine if the company has growth potential or is undervalued.
There you have it. These are the basic rules I have for income investing and I hope they play a part in helping you choose which companies to invest in and crucially also avoid those where the dividend may look attractive but actually isn’t sustainable.
If you wanted to take a deeper dive into a company’s financial position then, of course, you should. On top of these basic rules, it would likely, for example, be worth calculating return on equity and the debt-to-equity ratio.
I also focus just on shares. There is though the potential for income investors to buy bonds, most likely corporate bonds for higher yield.