If you are looking for shares that pay high dividends then there are 3 key dividend ratios that you can use to identify the best dividend paying shares.
In my post on Dividend Investment Strategy I mentioned the 3 key ratios that you can use to identify shares paying high dividends.
In this article, I will explain each of these 3 ratios in more detail and how to use them.
A dividend yield is calculated as the annual dividend per share divided by the share price.
So if a company pays an interim and final dividend, we need to add the two together to get the annual dividend.
If it pays dividends out four times, we need to add all four together, etc.
So, for example, if the interim dividend is 1.7p per share and the final dividend is 2.3p per share, the annual dividend is 4p per share.
The dividend yield and current share price are readily available in newspapers, company results or web sites for example.
So taking our dividend of 4p per share calculated earlier and dividing it by the share price (let’s say it’s 200p), our dividend yield is (4/200) x 100% = 2%.
Typically speaking, if the calculated yield is around 4% to 5% or higher, you have a high yielding share.
At the time of writing, this annual return is much higher than most UK bank savings accounts and thus explains why investors are looking to hold shares instead of cash in the bank.
However, that’s another story and not for today!
Occasionally, we will find a share with a very high dividend yield of say 10% or even higher.
Usually these are shares that have dramatically fallen in price e.g. because of a recent profit warning.
This is relatively easy to spot if we look at the historical share price graph for the company.
Sometimes, situations can arise where a company’s profits have been declining steadily over a period of time but the dividends paid have remained the same.
At some point then, it becomes necessary for the company to cut its dividend, to bring it more into line with its current and expected future profits.
This has happened recently to lots of shares during the recession of 2008/2009.
A ratio which can give us a clue about whether a company can continue to afford paying its existing rate of dividends is known as the dividend cover.
This tells us how many times the total dividends being paid (dividend per share multiplied by total number of shares held by all shareholders) are “covered” by the annual profits.
So if the total annual dividend paid is £50 million and the annual retained profits are £75 million, then the dividend cover is 75/50 = 1.5 times.
In other words, the company could have afforded to pay the dividends to shareholders 1.5 times over.
Dividend Payout Ratio
Companies that pay out a high proportion of their retained profits for a given year are said to have a high dividend payout ratio.
This is calculated as the total annual dividend paid divided by the annual retained profits.
So using the figures of £50 million dividends and £75 million retained profits, we get a dividend payout ratio of 50/75 = 66.6% i.e. two thirds.
Generally, a figure above 50% could be considered high, although it is not unusual to find a dividend payout ratio of 80%!
Notice that this calculation is the inverse (i.e. upside down) of the dividend cover calculation.
In other words, the higher the dividend cover, the lower the dividend payout ratio will be and vice versa.
If you have any questions for me on any of these, just leave me a comment below and I will answer…