Dividends uncovered: Are you paying too much for income?
Investing in stocks that pay large, growing dividends has become very popular. It's a sensible strategy, made all the more attractive by the slide in interest rates, which has made it ever harder to find a reliable investment income. While it's impossible to invest in stocks without risking your capital, dividends - once paid - at least represent a return that the dividend payer can't take back. So buying shares with decent dividend yields has seemed a relatively low-risk way to invest. However, the risk with any popular investment is that you end up overpaying, and so losing money. Read on to uncover if you're paying too much for income…
Let’s just remind ourselves of what the return from owning shares consists of, Phil Oakley in MoneyWeek
It boils down to the dividend yield when you buy, plus the dividend growth rate, plus the change in the market’s rating of a share over a given period. This is whether investors are willing to pay more or less for a given level of yield.
For example, say a company’s share price is 1,000c. It pays a dividend of 50c a share (a 5% yield).
Analysts expect the dividend to grow by 10% to 55c next year, and they think the market will keep valuing the company on a 5% yield.
This means the expected share price in a year’s time will be 1,100c (55c/5%). So the expected return from buying today is the 50c dividend plus a 100c gain in the share price, or 15%.
Dividend yields fall as share prices climb
If you look at companies that pay a good dividend and where they were in 2009 when the market bottomed compared to now, you’ll see their dividend yields are more attractive in 2009 than they are today.
Share prices have risen faster than dividend pay-outs have grown. This is because investors are willing to pay far more for each cent of dividends and profits generated.
As a result yields have fallen and price earning (PE) ratios
have risen. Analysts call this ‘multiple expansion’, and you often get it when interest rates are falling.
What’s worrying people now is if interest rates rise soon, this could send this process into reverse. In other words, we’ll see multiple contraction, where the amount investors are willing to pay for a given level of earnings drops, potentially hammering share prices.
This is a risk for most financial assets, not just dividend shares.
So there you have it, why share prices could be at risk because of their dividends.