Why dividends matter – and how to find them

A healthy dividend income is the cornerstone of any successful portfolio. Figures from ABN Amro show that £1 invested in UK shares in 1900 would have grown to £161 (not adjusted for inflation) by the end of last year on capital growth alone. But with reinvested dividends, that rises to £21,174 (see the chart on the right). And over the past decade, JP Morgan reckons the average share-price growth of UK stocks that regularly hiked dividend payouts was 12.7%; the market as a whole was 10.3%.

Dividends are good for firms

There are good reasons for this performance gap. Firstly, once a pattern of regular dividend payments is established, management teams get flak if they cut payments. This pressure to satisfy shareholders with hard cash focuses the business on the vital art of good cash management. This in turn lifts its performance, making future dividend payments more likely. Dividends are also tangible. Royal Dutch Shell's latest AGM was interrupted by a shareholder, objecting to a share buyback, who protested: "When you give me cash in a dividend payment, I can bank it where is the cash?" Share-price growth may be short lived, or even reversed when a company's fortunes change, but they can't ask you to return a cash dividend.

Finally, dividends contribute to share-price stability. If the share price of a dividend-paying firm falls, it is likely to fall less sharply than a pure growth stock. That's because once the price falls a certain distance, the yield (see below) picks up, encouraging investors back in. There is no such safety net for a share paying no dividend as many dotcoms found to their cost in 2000. So dividends are a vital consideration when stock-picking but how do you pick the best-income shares for your portfolio?

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Find a solid, well-covered yield

The dividend yield is the dividend expressed as a percentage of the share price. Take GlaxoSmithKline its full-year dividend for the last financial year was 49p. Based on a share price of £12.89, this gives a yield of 3.8% (49/1,289 x 100). Other big companies offering good yields include power generator National Grid (4.1%), HSBC (5.2%) and RBS (4.8%) in the banking sector.

The other vital point to consider is how well covered the dividend is. Cover measures by how many times the profit available to ordinary shareholders (a number you can read off the bottom of a profit and loss account) is more than the ordinary dividend. The higher it is, the more likely it is that the dividend can be maintained, or even raised. For a sound night's sleep, cover of above 1.5 is adequate two or more is ideal. On that basis, GSK (2.5 times) looks pretty solid, as does RBS (2.1 times) and National Grid (1.8 times). At 1.5 times, HSBC just about cuts the mustard.

Valuing shares using dividends

For large, stable companies, dividends also offer a way to value shares. Provided dividends and gearing (the debt to equity ratio) are fairly constant, dividend discount models' can be used. This technique assumes that a share is only as valuable as the future dividends it pays out, just as a property is only worth the future rental income from tenants. These dividends are assumed to grow over time to reflect inflation and the company's growth this in turn is unlikely, long term, to exceed the rate of GDP growth for the UK as a whole. Also, anyone buying shares expects to be compensated for risk, given that they could invest in something safer, such as gilts. A discount rate', therefore, cuts the value of future dividends to reflect the time value of money a £1 dividend received in two years is worth less than one received today.

Take BAT a large, stable company with a strong five-year dividend history. The model requires an assumption about BAT's long-term dividend-growth rate. Recently, this has been as high as 11% per year, but long term a realistic figure is the growth rate for the UK. We'll use 4.5% the UK's inflation target of 2%, plus 2.5% GDP growth. We'll also assume that the next dividend will be the same as the current one (56p), adjusted by our long-term growth rate, so 56 x 1.045 = 58.5. We assume this continues to grow at 4.5% indefinitely.

Lastly, let's say that our expected return from blue chips is around 8.5% (the average rate of return offered by the FTSE 100 since the early 1980s). Given that BAT has below-average risk (a beta' of less than 1 - see p.40 for a definition) we will use 7.5%. The basic Gordon growth' model suggests a share price of £0.585/(0.075 0.045) = £19.50 the perpetual annual dividend divided by the difference between the required return and the expected growth rate. The current share price is actually £16.64, so this simple model suggests the share might be cheap. It's certainly not foolproof as you can see, we've made many assumptions in putting this model together, such as the stable long-term dividend, assumed growth rate and the required rate of return. But for the right share, this is a useful starting point in the quest to find a bargain.