Many investors keep a close watch on company dividends, particularly retirees or those who are about to retire and need a reliable income stream.

But how do you identify good income stocks? A company’s dividend yield is a common starting point, but it doesn't tell the whole story.

What is a dividend?

A dividend is a distribution of a portion of the profits generated in any given year by a company or managed fund.

For Australian companies, they are most commonly paid twice annually—at the end of the first-half and full financial year—but may also be paid quarterly. Dividend details, including whether there will be one, how much, the format in which they'll be paid, and when is typically announced during company financial reporting.

By law this information must be provided to the Australian Securities Exchange, because it has very real—or “financially material”—implications for companies and their shareholders, as explained below.

But not all companies pay dividends. Companies at different points in their lifecycles, of various sizes (market capitalisations), and various sectors are more inclined to pay dividends than others.

From the perspective of Morningstar's company-level research, Morningstar director of equity research Adam Fleck says the types of stocks that should be at the top of your list are those with:

  • Economic Moats
  • Lower uncertainty ratings
  • Good management teams

And for specific income-generating companies, Fleck suggests looking at the growth of dividends over time, the volatility of company earnings and the reinvestment potential—that is, how much money management is likely to tip back into the business to keep it growing.

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Typically, companies that pay dividends are those that have been in business for more than a few years—as opposed to start-ups that might be promising investors lots of blue-sky upside.

Who pays dividends?

Over time, a more mature, successful company is more likely to generate excess revenue, beyond that needed for its day-to-day operations.

Sector-specifics aside, excess corporate cash can either be reinvested in the company (capital expenditure, or cap ex) or paid to shareholders as a dividend or some other form of capital return, such as a share buyback.

Companies sometimes pay dividends because they can’t find enough promising projects to invest in for future growth, so they return a higher proportion of profits to shareholders. This is where Fleck's above suggestion about keeping an eye on reinvestment potential is prudent.

Smaller, newer companies are less likely to have excess capital, with more of their revenue used to fund ongoing operations and expansion efforts. As such, they don't usually pay a dividend yield.

Sectors that are generally more likely to yield income include: utilities, basic materials (commodities) and financial sectors. But this isn't always the case.

"If you look across banks, real estate investment trusts and miners, they're likely to pay out the vast majority of their earnings as dividends,” says Fleck

“But as we've seen, in downturns even these companies' dividends can be at risk.

"We talk about needing to look outside the box, and income stocks can also come from outside those traditional sectors."

That said, Morningstar's latest analysis on some of these sectors indicates utilities and REITs are likely to outperform, despite understandable skittishness about the sustainability of dividends.

Income investors have long favoured bond proxy stocks such as utilities and REITs, says Morningstar equity research director Johannes Faul.

"The reason is record low interest rates, spurring on the hunt for yield. Some more traditional income stocks in sectors like utilities and real estate are undervalued and we expect them to grow dividends again from near-term troughs," Faul says.

Two prominent examples are AGL Energy (ASX: AGL) and Charter Hall Social Infrastructure REIT (ASX: CQE).

Ian Bailey, principal and co-founder of Bailey Roberts Group financial planning, manages the investment portfolios for a large number of self-managed super fund investors.

Especially for investors that are in pension phase already, he says it's critical to ensure that the companies you hold have healthy cashflows.

"When you're running a pension, you've got to sell units to generate income.

"In a downturn, of course those units will have decreased in value, so you've got to sell more of them, and that has a huge impact on future growth of your investment," says Bailey.

For this reason, Bailey Roberts is focused on having companies with cashflows on their books—or sufficient cash on hand—so that you don't have to worry about fluctuations in the market when you're drawing down.

"We always try to seek high dividend-paying stocks, but they also need to meet the other criteria.

"The companies also should have products and services that we can see society and businesses are going to want or need in the future.

"You can't always get it right, but se don't focus on getting our clients high returns, we're focused on looking after their capital."

What is dividend yield?

Dividend yield has long been considered a key measure of company valuation. It is a comparative measure of company's past-year income distributions divided by its current public offering price, expressed as a percentage.

The dividend yield is equal to a company’s annual dividend per share, divided by its stock price per share.

So, if a company pays an annual dividend of $2 and has a stock that trades for $100, its dividend yield is 2 per cent. If that same stock’s price fell to $50 per share, its dividend yield would rise to 4 per cent.

The reverse also applies—as the stock price rises, the dividend yield declines.

"But you can't guarantee what dividend yields are going to be. For example, banks have cut dividends at the moment," Bailey says.

"If you lose 5 per cent in dividends, that's something, but if you lose 50 per cent of the stock value, that has a far greater impact than your dividend being reduced … it's important to have a broader understanding of the business that you're buying into," Bailey says.

Dividend traps

Looking so closely at dividends that you miss the important details about the companies you're buying can leave you vulnerable.

As Fleck explains, if a company is holding on to an extremely high dividend yield, it could mean that they're about to pay a dividend.

"Or, they're putting long-term shareholders at risk from a capital destruction standpoint," he says.

"For example, if they're leveraging up their balance sheet then they're borrowing from the future to pay present shareholders."

In many ways, Morningstar analysts don't care whether the free cash flow generated by a company remains on the balance sheet; is paid out in dividends or share buybacks—as long as the free cash flow is there.

"Ultimately, it's still shareholder cash," Fleck says.

He concedes this is an overly simplistic and intentionally naïve view, and acknowledges the income needs of investors, particularly retirees.

"But from a returns perspective, if a company chooses to hold on to its cash and invest in higher returning projects, the returns on those projects could surpass the returns you as an investor would enjoy from reinvesting the dividends."

For example, a big acquisition might lead to shareholder returns of between 7 and 10 per cent over a number of years.

"While it takes longer to crystallise that value, you don't want to take the short-term gain because that might be offset by longer-term reward," Fleck says.

"And sure, there's the counterparty risk of having the company hold on to that money.

"I appreciate that people looking for income might be willing to pay a little more for a company to get that income … but it's not the primary way we're valuing stocks."