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When considering dividend yields, UK investors tend to be wary of the 7% mark. This is often thought of as an area where the sustainability of payments is questionable. If a company allocates too much cash to dividends it can lead to operational problems and poor performance.
Meanwhile, dividends are often cut, leaving shareholders dissatisfied. This in turn prevents new investment, leading to recession.
There are occasional exceptions to this rule but it is considered a good rule of thumb to stick with it.
With that in mind, I prefer to aim for an average yield of around 6% to stay on the safe side. Products in such a portfolio may sometimes lose more than 7% but usually break even.
Look beyond the harvest
Even a yield of less than 7% does not guarantee anything as the company can still make payments. To really check the sustainability of payments, it helps to check the credit and free cash flow.
Companies use their free money in different ways. It can be saved, used to reduce debt, used to buy shares, or used to pay dividends.
Debt is not a problem as long as the interest payments are covered. If not, the benefits can face the block. But with cash flow and debt well covered, there would be little reason to cut dividends.
Don’t forget to separate
Businesses in similar industries tend to have similar financials. So when looking for a sustainable yield, an investor may end up choosing four insurance companies. Sure, they can all be reliable dividend payers but the portfolio will be heavily exposed to one sector.
It would be better to choose a very reliable stock with a high yield from four different industries. Diversity is about balance.
Two examples
Think about it National Grid again ITV (LSE: ITV). They operate in diversified sectors with consistently high yields and multiples of multiples.
As the UK’s largest gas and electricity supplier, National Grid is a company that enjoys consistent demand and stable income. Its operations are well regulated, so it tends to be stable, with annual profits increasing continuously for more than 20 years.
But it faces pressure from rising energy prices and expensive upgrades to meet decarbonisation targets. This has resulted in rising debt, a problem compounded by rising interest rates. As cash flow dwindles, it recently cut dividends by 15%.
On the other hand, ITV has enjoyed equity growth while reducing its debt recently. It does not have the strong payment record of National Grid but enjoys stable cash flow. This reduces the chance of dividend cuts, making the 7% yield attractive.
Competition is fierce, however, and the popularity of Netflix, Disney, again Amazon hustle in the digital broadcast market. While ITV continues to extract a decent amount from its Studios arm, profits are at risk of being lost in broadcasting.
This has contributed to a slight drop in revenue in 2023, from £3.73bn to £3.62bn. But its results for the first half of 2024 show some recovery, with revenue up 2.4% and profit margin rising to 17% from 2.6% last year.
These examples show how dividend stocks can differ, yet both remain popular options and should be considered as part of an income portfolio.
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