Like many people, I appreciate earning dividends from income shares. But sometimes what looks like it could be a good income share turns out to be a value trap. After buying it, the dividend gets cut and as a result the share price falls. So not only do I get less dividend income than expected (or none at all), but the value of the shares is less than I paid for them.
That is why, when hunting for income shares I can add to my portfolio, I always look out for three features.
Future income potential
To pay dividends, a company needs to make money. So the first thing I look at when considering a share for my portfolio is how the business makes money and whether I think it can continue to do so.
For example, I may look at the business model, what sets a firm apart from its competitors and how large customer demand is likely to be in future. It is easier to do this if I understand the business model, which is why like billionaire investor Warren Buffett I always try to stay inside my circle of competence when investing.
Income shares and dividend strategy
Some companies – but not all – have an explicit dividend strategy. That is when the management lays out what they hope to do in future. For example, a progressive dividend strategy means that the company will aim to raise its dividend per share each year.
In practice, no dividend is ever guaranteed. A dividend strategy does not have to be delivered. But I still take it as a good indicator when looking for income shares. I reckon it shows that management is thinking ahead about how to pay profits out to shareholders. I like that focus.
Dividend coverage
Dividend coverage refers to whether a dividend is adequately covered by a company’s earnings or free cash flow. I tend to look at both measures, but pay more attention to free cash flow. That is because earnings are an accounting measure, whereas cash flow looks at the actual hard cash coming in or out of the business each year. As that is what is needed to pay dividends, I think it is the more useful of the two measures in the context of income shares.
The better covered a dividend is, the greater the margin of safety the dividend has. That does not mean it is safe though. Earnings or cash flow could tumble, after all, cutting the coverage.
So why do I look at dividend coverage? Basically if a dividend is barely covered or even not covered consistently over a period of years, it would be a red flag for me about how sustainable it may be.
That would not necessarily put me off buying the shares – Persimmon, for example, barely covers its dividend but I would still consider buying its shares. But that is because it has a 13% dividend yield. If it had a far less attractive yield and the dividend was barely covered, I would not consider the shares for my portfolio. If an income share has neither an attractive yield nor a good dividend coverage, I would be unlikely to buy it for my portfolio.