How to seek out healthy dividends

"Do you know the only thing that gives me pleasure? It's to see my dividends coming in." So said John D Rockefeller and while you might think it reflects a rather narrow view of life, it does highlight the crucial role of the dividend (a proportion of a company's profits paid out to shareholders) when it comes to investing in stocks.

Dividends fell out of fashion in the dotcom years because the emphasis was on capital gains from risky, fast-growing technology firms that ploughed all their earnings back into their business in order to grow more quickly. But post-crash investors have rediscovered the appeal of dividend cheques, not least because dividends can't be fudged they have to be paid with real money. The clamour for less glamourous stocks providing income has resulted in a sharp uptick in the UK five-year average dividend-growth rate to 7%, according to the annual Barclays Capital Equity Gilt Study; overall dividend income in the UK has risen by almost 40% since 2001.

That's good news given how important dividends have been in the past reinvested dividends account for the bulk of long-term equity returns. The Equity Gilt study calculates that £100 invested in British stocks in 1899 would now be worth just £213 in inflation-adjusted terms without reinvesting the income, but £25,022 if the dividend income is added. Starting with £100 in 1945, the respective real figures are £302 and £4,531. And as Robert Cole points out in The Times, "the enrichment garnered over much shorter periods remains attractive". Adding reinvested dividends to capital gains of the FTSE 100 since 2002 implies a level of 7,500 for the index; doing the same from 1988 onwards leaves it at over twice its current level. In the US, meanwhile, dividends have accounted for almost half of the S&P's return over the past 75 years, says Paul Tracy on Streetauthority.com.

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The statistics reflect the fact that dividends, and hence dividend yields (the annual dividend per share divided by the share price), rise over time they have expanded by an average of 6%-7% every year in the UK since 1945. As Nick Louth points out on Money.uk.msn.com, a 20% yearly rise in the dividend on a stock yielding 1% boosts the yield on the initial investment to 5% in a decade. Similarly, a 6% annual dividend rise on £100 of stocks yielding 4.5% would almost triple the yield to 13.1% on the initial investment in two decades. Reinvesting, that yield would have boosted the total payout by a factor of 15. And all this is before capital appreciation.

Furthermore, a high yield often tempers share-price declines, as income seekers will be drawn to a rising yield as the stock falls; without a dividend, there is no such buffer. US dividend payers "could be counted on" to deliver stronger relative returns in difficult markets than non-payers in the US between 1970 and 2000, notes Tracy. When it comes to assessing dividend stocks, a generous yield often signals value, but an unusually high one can indicate a firm in trouble. Seek out firms with a consistent record of growing dividends companies are always keen to avoid upsetting investors by cutting payouts.

One way of checking if a stock's dividend is secure is with the dividend cover ratio (post-tax profit divided by the total amount paid out in dividends included every Monday in the FT share listings). In general, cover of under 1.5% may presage a cut, while over three is comfortable, reckons Motleyfool.co.uk. Check the net cash position too: a firm undergoing an earnings slowdown with plenty of cash "is much more likely to carry on paying the same level of dividends".