A common way to try to build passive income is to buy dividend shares. But dividends are never guaranteed – and even if they are paid, share price movements can also affect the overall return from a given investment. So, when looking for income stocks to buy for my portfolio, here are three things I try to bear in mind.
Yield is a historic snapshot, not a guarantee
When looking for income stocks to buy many investors pay close attention to a company’s dividend yield. But that is only a snapshot of what the company has paid out in the past.
There are all sorts of reasons why even a strong company might cut its divided. Business performance may be weak. Or a company may be in a cyclical industry like mining, meaning that cash flows suddenly fall dramatically and a longstanding dividend gets the axe for the foreseeable future. Or could simply be a change in management priorities, using spare cash for a purpose other than a dividend.
As an investor of course I look at a company’s yield when assessing its shares, but I try to focus more on what I think the likely future dividend (if any) will be.
Income can come at the price of growth
Those management choices about how to deploy spare cash matter.
Legal & General is one income stock many investors look to buy when they want to boost their dividend streams.
As it is the highest-yielding share in the FTSE 100 index, at 8.1%, I understand that.
But over the past five years, the share has moved up just 8%, whereas the wider index has moved up 59%.
Might the Legal & General share price have performed better if management had used more spare cash to fund business growth, rather than supporting a beefy dividend?
It is possible, though in reality it is hard to second guess hypothetical scenarios. What we do know is that some companies prioritise dividends at the cost of growth and, over time, it hurts their performance.
When looking for income stocks to buy, I always try to bear that in mind.
Dividend cover matters
I also consider how well covered I expect a dividend to be. I look at earnings, but I also look at cash flows as dividends are ultimately a cash cost.
For example, B&M European Value Retail (LSE: BME) issued a profit warning last week, saying it plans to cut prices to shift stock. That could hurt operating cash flows.
In its interim results, the ordinary dividend of 3.5p per share was amply covered by adjusted diluted earnings per share of 7.2p. It was also covered, but less comfortably, by statutory diluted earnings per share of 5.2p.
But net cash financing outflows of £377m were bigger than net cash operating and investing inflows of £326m. That was not just due to the dividend, but clearly the dividend added further strain on the cash flows.
B&M remains profitable and is generating sizeable cash flows at the operating level. With its strong brand and large customer base, I plan to keep holding the shares.
However, I am mindful of the possibility that management may decide the current balance of cash flows could be improved by reducing the total amount spent on dividends.
