Finding the best UK dividend shares doesn’t necessarily mean searching for the highest dividend yields. In fact, that approach can often lead investors into traps. The real winners are the companies capable of amplifying their dividends over time, even during periods of economic uncertainty.
But how can I spot these passive income opportunities early on to try and reach early retirement? Let’s explore.
Avoiding misleading dividend shares in 2022
2022 has been quite a volatile year. As fears of a recession continue to rise on the back of higher inflation, many stocks have plummeted, sending yields up.
Does this mean there are buying opportunities for high-yield stocks? Absolutely. But as I’ve already said, buying based solely on yield can be a recipe for disaster.
It’s important to remember that a healthy dividend is paid using excess earnings that a business has no better use for. But with rising costs, consumer spending slowdowns, and other hurdles created by the current economic environment, most companies will likely need to retain as much capital as possible. This is especially true for dividend shares servicing large piles of debt.
If cash flows become compromised, dividends are almost guaranteed to follow suit. And when cuts are announced, not only does the once-attractive yield get slashed, but the share price often suffers significant declines as investors move on.
Building a reliable passive income for early retirement
So how can I spot the difference between an opportunity and a trap? In my experience, there are two primary factors to consider.
The first is the payout ratio. By dividing the gross dividends by a company’s net income, investors can quickly gauge how much profit is being redistributed.
While there are exceptions, in my experience, a payout ratio higher than 65% can signify unsustainability. Why? Because if earnings take a hit, dividend cover can get pretty tight, likely resulting in an eventual cut to maintain the firm’s financial health.
The second factor is income growth opportunities. Unless I already have a massive seven-figure portfolio, an average 4% yield isn’t going to cut it for early retirement. But by investing in dividend shares capable of growing their payout each year, that 4% can expand considerably.
For example, thanks to Coca-Cola’s continuous dividend increases, Warren Buffett’s original investment in 1988 now generates an annual yield of over 52%!
Finding the next Coca-Cola of dividend shares is obviously easier said than done. The stock market can be volatile, and not all businesses will live up to expectations. And as 2020 perfectly demonstrated, even some of the best income stocks can become severely compromised by external factors. Needless to say, that can throw quite a spanner in the works when building a retirement nest egg.
This is why diversification plays a vital role in any balanced portfolio. By owning a collection of companies with proven business models, solid fundamentals, and plausible long-term growth strategies, the adverse impact of one business failing can be mitigated.
And that helps open the door to an earlier retirement.