Dividend shares are extremely popular at the moment because of how low interest rates have gone.
But it’s important to not get sucked into the wrong investment just because of a potential dividend.
There’s no use getting an 8% dividend yield if your investment goes down 20% in value, so you need to make sure you don’t overpay for a share even if you’re just buying it for the dividend. I’d want to think about these factors before buying a share for a dividend:
Has the dividend been stable in the past?
There’s so much information at our fingertips these days. We can see what a business has paid out in the past during events like the GFC and the resources bust in 2016.
The GFC was (hopefully) a once-in-a-generation event whereas resources regularly go through cycles. BHP Group Ltd (ASX: BHP) and Woodside Petroleum Limited (ASX: WPL) often offer good yields, but 2016 showed how unreliable dividends from resource businesses can be.
It’s okay if you’re happy to hold through the cycle, but if you rely on the income then I’d only want to buy resource shares at the bottom of the cycle rather than near the top.
Does the dividend look sustainable for the foreseeable future?
No-one wants to suffer from a dividend cut, so you need to think whether your dividend share actually has a sustainable dividend. Is competition going to force a dividend cut? Is the company paying out too much profit?
A few years ago Telstra Corporation Ltd (ASX: TLS) was paying out all of its profits every year. As soon as its earnings fell the dividend fell too. You could argue that the bank dividends aren’t very secure with rising capital requirements, higher competition and ongoing customer remediation.
Is the business growing?
If you want the dividend to grow then it needs to be funded by earnings growth. Does that company have growth in its future? Is it growing overseas? Is it re-investing for growth? Is it exposed to a good tailwind? Is its profit margin going up? Something has to create profit growth to support dividend growth.
The best businesses to own will almost definitely be earning more in five years and ten years. That’s how shares like REA Group Limited (ASX: REA) and Washington H. Soul Pattinson and Co. Ltd (ASX: SOL) have managed to achieve such good dividend growth over the past decade – long-term profit growth, increasing earnings diversification and re-investment back into new opportunities.
I think Soul Patts along with these wonderful dividend shares are some of the best income ideas on the ASX.
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Motley Fool contributor Tristan Harrison owns shares of Washington H. Soul Pattinson and Company Limited. The Motley Fool Australia owns shares of and has recommended Telstra Limited and Washington H. Soul Pattinson and Company Limited. The Motley Fool Australia has recommended REA Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.