How dividends help you to get rich slowly

If there’s one trait you need to be a successful investor, it’s patience.

We all spend lots of time daydreaming about ten-baggers (that is, shares that make you back ten times the money you invested).

These sorts of gains do exist. And we’ll talk more about how to go about stalking ten-baggers and other rampant growth stocks in future emails.

But the truth is that if you want to make money over the long run, you can’t ignore dividends.

This might seem dull. The prospect of earning 4% a year on your big blue-chip investment pales by comparison to the 400% you dream of from that tiny oil explorer.

But in fact, over the long-run, as long as you reinvest them, your dividends are likely to make you more money than you get from capital gains.

If you’d put £100 in the UK stock market at the end of 1945, it would have been worth £7,401 by the end of 2011, according to the 2012 Barclays Equity Gilt study.

But if you’d reinvested your dividends in the market, that £100 would now be worth more than £130,000.

This makes sense. A company can only grow its dividend in a sustainable way if its earnings are growing too. Rising earnings should lead to a rising share price in the long run.

This is why we think that having a core part of your portfolio devoted to income is a good idea. And shares that pay solid, reliable dividends, are one way to generate a good income.

What to look for in a dividend-paying stock

So what should you be looking for in a dividend-paying stock? There are two main things: is the company paying a decent yield in the first place? And is it sustainable?

The dividend yield is easy to calculate. It’s simply the annual dividend payment, divided by the current share price, expressed as a percentage. So if a company pays an annual dividend of 5p, and the current share price is £1, the dividend yield is 5%.

As a starting point, you should be looking for a dividend yield above the market average. So if the average FTSE 100 dividend yield is 3%, you’d be looking for companies paying more than that.

After all, if your main goal is to generate income, there’s no point in going for a low yield.

However, you also need to be wary of stocks offering unusually high yields. Companies are under no obligation to keep paying dividends. So an unusually high yield is sometimes a sign that investors don’t believe the company is actually going to pay out.

And if a dividend is cut, you can lose a lot of money. There’s the loss of dividend income for a start. But the share price also tends to fall too.

Investors who may have held a share for its high dividend will often sell when the dividend is cut and look elsewhere for a more reliable income stream.

So how do you know how safe a dividend is?

You can check the safety of a dividend by calculating its dividend cover. This looks at how many times a dividend can be paid out of a company’s profits.

Dividend cover is calculated by dividing a company’s earnings per share (EPS) by its dividend per share. EPS is straightforward to find – it’s one of the categories on our share performance tables.

So, if a company has EPS of 100p and a dividend of 50p per share, its dividend cover is two times profits. This level of cover usually tells you that a dividend is fairly safe. For most companies, you may start to worry once dividend cover goes below 1.5 times.

However, it’s also important to consider the type of business you are investing in when looking at dividend cover.

For example, water companies have very stable profits. This means they can pay out most of them as dividends, as they can expect to be able to cover the dividend. So a dividend cover of 1.3 times is quite normal.

On the other hand, a manufacturing company – where profits can go up and down a lot from year to year – with the same level of dividend cover would be a warning sign. The dividend could be at risk of being cut.

As you need cash to pay dividends, professional investors increasingly look at a company’s cash flow when checking for dividend safety. We’ll talk about that in another article.

No safety check is infallible. Unexpected events can hit any single company (just look at BP’s disaster in the Gulf of Mexico for example). These sorts of events are impossible to predict.

Of course, this is why you never put all your money in one stock. For a decent income portfolio, MoneyWeek’s dividend expert Stephen Bland reckons that between 16 and 20 should be enough, as long as they are diversified across different sectors.

What to do now

If you already hold dividend-paying stocks in your portfolio, try to calculate their dividend cover for yourself.

You can find EPS on the MoneyWeek website for most UK-listed stocks (here’s the FTSE All-Share list), and you should be able to find the dividend per share figure from the company’s website.

If the dividend cover seems particularly low, try to think why this is. Is the company in trouble? Or is it in a sector where profits are particularly stable (‘defensive’)?

And if the cover is high, is this because the company is being stingy with its payout? Or is it in a sector where profits are more volatile (‘cyclical’)?