A dividend checklist for income investors

UK dividend payouts grew by 14.5 percent to a record £37.8 billion in the second quarter of this year. The figures were boosted by a handful of large special dividends and the effects of the weaker pound. But behind the scenes, underlying dividend growth of five percent was actually slightly weaker than some analysts thought it would be.

Part of the problem - according to the latest dividend data from Link Group - is down to pressure on corporate earnings. A slowing world economy and uncertainty on the domestic front are reasons why dividend growth is slowing across the board. That said, large-cap company dividends, which tend to benefit more from the uplift of weaker sterling, grew much faster than those from mid- and small-caps.

Some of the strongest payout growth was found in the financial sector, with banking dividends up by two-fifths, boosted by a special payout from RBS. During Q2, the bank made only its second payment in over a decade. But over past twelve months it has apparently paid out twice as much as it did in 2007 - the last year before banking stocks hit the buffers in the financial crash.

Looking ahead, the latest research predicts that UK shares are collectively set to yield 4.2 percent this year, which is weaker since the start of the year but still higher than historical norms.

So for investors looking for dividend income, which factors matter most when it comes to weighing up a dividend? Here we’ve pulled together and explored some of the most common dividend measures and looked at what you might find if you applied them as part of an equity income strategy...

1. High (but not excessive) dividend yield

Yield is perhaps the ultimate dividend metric. It tells you the percentage of how much a company pays out in dividends each year relative to its share price, which makes it easy to compare stocks. High yields are obviously appealing, but caution is needed. When the market anticipates a dividend cut, the share price will fall, which actually pushes the yield higher - making it a so-called ‘dividend trap’. So it pays to be wary of excessive yields.

2. Dividend cover

Attractively high yields obviously turn heads - but it’s important to know that a dividend is affordable. Dividend cover is a go-to measure of a company's net income over the dividend paid to shareholders. It’s calculated as earnings per share divided by the dividend per share and helps to indicate how sustainable a dividend is. Dividend cover of less than 1x suggests that the company can’t fund the payout from its current year earnings. Ideally you’d set a minimum limit of at least 1.5x.

3. Cash generation

Dividends are ultimately paid using real cash that the company has available. So it makes sense to take cash flow into account. By checking that a company’s free cash flow per share is higher than the dividend per share that it pays out, you can get an extra sense of the kind of headroom the company has when it comes to funding its dividend.

4. Dividend growth

Another potentially important marker for income investors is a track record of dividend growth. Progressive dividend rises can be a pointer to payout policies that are being handled carefully by management. Rather than aggressively dishing out cash, dividend growth companies tend to have more modest yields, but can be better at sustaining their payouts over time. For our purposes we looked for a minimum of five dividend increases over the past 10 year period.

5. Forecast dividend growth

A track record of dividend growth is encouraging but it’s important to know that story hasn’t changed. Analyst forecasts can be inaccurate but paying attention to dividend growth forecasts for the coming can be a useful way of telling that there isn’t any bad news out in the market that you might have missed.

6. Positive relative price strength

While it’s not a dividend measure on its own, positive relative price strength tells you that a company’s share price has outperformed the market over the past year. It’s a useful initial check in making sure that there hasn’t been a specific problem with the stock in the recent past, such as a profit warning or some other reason why the share price has fallen sharply and pushed the yield up.

Screening the market

We took these measures and applied them as part of a strategy that looks for reasonable yields and dividends that appear to be sustainable, well managed and forecast to grow further. You can find the screen here.

The yields here range from 3.7 percent at the transport group National Express to 7.5 percent at home builder Taylor Wimpey. These rules tend to pick up large, solid, cash-generative businesses with a track record of growing their dividend payouts. Although the market caps range from the £5.7bn tech group Micro Focus to the much smaller consumer products from Norcros, which is valued at £172 million.

A checklist approach to dividends

There are various strategies for finding dividend stocks. For the most part you can divide them into the three main categories of High Dividend Yield, Dividend Growth and Dividend Safety. High yielding stocks are naturally eye-catching, but dividend growth and dividend safety are much more focused on finding sustainable payouts from well managed and adequately financed companies. Blending these different approaches can be a useful way of coming up with a more rounded strategy - and set you on the path to finding the market’s best dividend stocks.