Are you paying too much for income?

There are a few simple ways to find out, if you are paying too much for dividend stocks. Phil Oakley explains what they are.

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 can't be taken away. 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.

Are investors paying too much for dividend stocks? There are a few simple numbers you can crunch to find out.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Let's just remind ourselves of what the return from owning shares consists of. 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 whether investors are willing to pay more or less for a given level of yield.

For example, say a company's share price is 100p and it pays a dividend of 5p a share (a 5% yield). Analysts expect the dividend to grow by 10% to 5.5p 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 110p (5.5p/5%). So the expected return from buying today is the 5p dividend plus a 10p gain in the share price, or 15%.

Below I've looked at five popular dividend payers, how they were priced in March 2009 (when the market bottomed) and what they cost now.

In 2009, yields were more attractive than they are today. Share prices have risen faster than dividend payouts have grown, because investors are willing to pay far more for each penny of dividends and profits generated. As a result yields have fallen and price/earnings (p/e) ratios have risen. This is known as multiple expansion', and you often get it when interest rates are falling. Diageo and Vodafone have each seen big gains from multiple expansion and now look quite expensive.

The shares of British American Tobacco, Reckitt Benckiser and National Grid, however, have been driven more by dividend growth their p/es have not soared at the same rate. What's worrying people now is that interest rates may rise soon, which 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.

But it is worth remembering that interest rates haven't actually changed much since March 2009. Ten-year government bonds yielded 3.08% in March 2009, compared with 2.8% now hardly a huge drop. So it is possible that bond yields could rise quite a bit higher before dividend and earnings multiples start to drop.

All the same, because some dividend stocks look expensive, many experts are now focusing on the potential for dividend growth, rather than just hunting for high yields. The hope is that this promise of growth can offset the risk of multiple contraction.

How can you work out how much dividend growth is already factored into a share price? I won't get into the maths here, but there is a simple calculation that helps, based on the well-known Gordon Growth Model (which estimates share prices based on dividends). Using this, the expected long-term dividend growth is the investor's required return (say 8% a year), minus the dividend yield.

Swipe to scroll horizontally
Row 0 - Cell 0 Implied dividend growth
March 2009NowForecast divi growth
Reckitt Benckiser4.80%5.21%3.5%
National Grid2.21%2.74%3.2%

What you can see is that the price of each company implies higher dividend growth now than in March 2009. But over the long haul, dividends can't realistically grow by more than nominal economic growthsuggests that if a share price implies dividend growth of more than 5%, it's expensive.

You can also compare implied growth with dividend forecasts for most big companies and see if there is a mismatch. On this view, investors in Diageo, Reckitt and Vodafone may be expecting too much. But British American Tobacco and National Grid which have implied dividend growth below both 5% and the forecast dividend growth could still be of interest to dividend hunters.

Swipe to scroll horizontally
Row 0 - Cell 0 March 2009November 2013Change
Row 1 - Cell 0 DiviShare priceYieldP/eDiviShare priceYieldP/eDividend growthShare-price change
Reckitt Benckiser80p2,503p3.2%15.8134p4,801p2.8%18.367.5%91.8%
National Grid33p570p5.8%13.740.85p776p5.3%13.423.8%36.1%

Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.


After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.


In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.

Follow Phil on Google+.