How to mix dividend yield and earnings growth to find stronger total returns

When it comes to stock market returns, dividend yield is one of two components that determine what you might expect to achieve from owning a share (the other being a change in its price). But yield can also tell you a lot about the nature of the stock and what the market really thinks about it.

A lot of what’s written and reported about dividend yield tends to treat it in isolation: from news stories in the press through to investment books and even entire dividend strategies.

This does make some sense, of course, because dividends are a major source of returns over time. But there is a bigger picture to think about. To pay dividends, companies need stable earnings that are preferably growing. And over time, earnings growth is also a major contributor to rising stock valuation (which ultimately drives share prices).

This means that dividend payouts and capital gains are two sides of the same ‘return’ coin. They are intertwined. Even if you insist on prioritising dividends, ignoring questions like whether a company is capable of growing its earnings, can eventually leave you exposed to ‘dividend traps’.

What’s preferable is to approach capital gains and yield together, and focus on what’s known as total return.

In this article I’m going to explore the role of yield in investing, how it contributes to total return and how you might choose to use it in your own strategy.

Understanding the appeal of high yield

First, here’s a primer on what yield is and how different variables can influence it…

Yield is used as a measure of return in a variety of different asset classes. With shares, it’s a measure of the cash returns (dividends) that companies make to their shareholders. They pay dividends from their net earnings, or net profit. This is the same profit pot that they can either retain or reinvest in themselves, or use to fund share buybacks.

To calculate a dividend yield, divide the company’s share price by its dividend-per-share and multiply that by 100.

For example, if a stock is paying 10p per share in dividends and has a share price of 500p, then the dividend yield will be 2.0% (10 / 500 x 100 = 2).

Paying dividends can be a sign of maturity in a business, but it’s not always defined by size. It’s not unusual to find small (often owner- or family-controlled) companies that pay dividends, as well as large stocks that don’t pay them.

A major factor that makes dividends appealing is the regularity of a cash return. Income generated from a portfolio of dividend-paying shares can be reinvested or withdrawn without having to liquidate the initial investment and potentially trigger taxes. Against that backdrop, it’s easy to see why high yield is seen as so desirable by many investors.

Making sense of dividends and yields

An important point about the yield calculation (above) is that companies don’t have full control of all of the factors that influence what the yield is.

One that can be controlled is the dividend-per-share. This tends to be worked out carefully based on long-term plans and outlook. Stability is usually key because varying payouts up and down, year to year, can look like poor management.

By contrast, share prices change constantly, and companies rarely have any control over them. Often they’ll move in response to changes in the outlook, but they can also move in response to general market conditions. For this reason, dividend yields can change on a daily basis.

All else being equal, a rising share price has the effect of lowering the yield, while a falling share price will increase the yield.

A broader factor to consider is that yields can vary a lot depending on where a company is in its lifecycle and the sector it’s in.

For example, generally speaking yields tend to be higher in large, slow-growing, cash cow type companies. This is particularly the case in areas like utilities, financials and ‘sin industries’ like tobacco and oil amp; gas. Income investors have historically found these types of stocks appealing for their dependable dividends and above-average yields.

By contrast, smaller companies, especially in more cyclical and innovative industry groups, often have below-average yields.

The risks with high yield

While high yield certainly appeals to many investors, it’s important to be wary of some risks.

Unlike bonds, stocks that pay dividends are not fixed income investments. That means your original investment in a stock might fall in value. There is also a risk that the company may cut or cancel its dividend altogether.

This risk exists because no matter how good a company is, earnings are not guaranteed. If it hits trouble or there is some unexpected change in its outlook, dividend payments could easily be cut.

Buying shares because of their high yield only to find that the dividend is cut later on is what’s known as the dreaded dividend trap.

Ironically, one of the best early warning signs of a possible dividend trap is an unusually high yield. Typically, when the market becomes concerned about a company’s outlook (and perhaps even its ability to fund the dividend) the share price will fall, which drives up the yield.

This is particularly dangerous territory for the unwary high dividend yield hunter. But it’s also the reason why value investors use high yield as an indicator of potential mispricing (although they will also want to know that the payout can be sustained).

Why dividends and earnings go hand in hand

Given these potential risks with high yield, it can make good sense to pay attention to a company’s earnings track record. In this article I explored the basics of doing that by using earnings and sales growth to find potential investments.

Screening the market for stocks with above average yields and earnings that appear to be solid and growing provides a more complete investment picture. A focus on earnings growth is arguably more likely to find stocks with well-funded, reliable payouts, as well as greater capacity to see their valuations (and share prices) rise over time.

Taking this approach means focusing on ‘total return’, the bulk of which is made up of capital gains on the original investment plus dividends paid. In some cases, you might also include the impact of special, one-off dividend payouts (not included in the regular yield) and share buybacks.

To construct a set of screen rules to look for higher yield and earnings progression, you can begin by creating a New Screen in Stockopedia and then clicking Add Rule.

Dividend data in the ratio picker can be found in the Dividends section on the left-hand side. Here we’re selecting from the Yield section, but there are also ratios covering Dividend Growth and Safety.

Yield can be measured as an average over time, or on a trailing 12 months or rolling forecast basis. In this case I’ve added the trailing yield to the screen twice to create ‘upper’ and ‘lower’ thresholds (a minimum yield of 3.5% and a maximum of 10%). This focuses the results on above-average yields but cuts out anything that might be excessive.

Dividend Cover of 1.3x looks for companies with dividend payouts that are covered by more than 1.3 times their net profits. For even greater security, you could increase the minimum dividend cover.

The Annual Dividend Streak of 5 or more means that all companies in the results will need a track record of more than five consecutive years of dividend payouts over the past 10 years. This rule is really about looking for a track record of consistency, but it forgives any reductions in the payouts.

To cover the requirements for earnings progression over time (and recently) the screen rules look for both sales and earnings growth of more than 5% and a Return on Equity of more than 10%.

Here is what the table of results will look like:

Subscribers can see the full screen here

Balancing income and capital growth

Overall, high dividend yield holds strong appeal with many investors, but there are reasons to be wary of investing in shares on yield alone.

Dividends paid by quoted companies can be volatile and susceptible to unpredictable factors that are sometimes impossible to control. At worst, this can mean being stuck in a dividend trap, where the payout has been cut and the share price has tumbled.

To avoid this, adding simple additional measures to a dividend strategy could offer some protection. A solid earnings track record is one option, but there are a variety of ‘growth’ and ‘safety’ rules that can be used.

These tactics can not only help to pinpoint yields where the dividends have a higher chance of being sustained, but also highlight stocks that are growing and may see their share prices trend higher as a result. This total return approach is a way of not relying on one particular source of return, but instead aims to get the best of both.

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