Imagine having a drip feed of cash to pay your bills or a regular supply of money that you can use to make new investments, neither coming from your salary. That’s the ultimate appeal of income-paying instruments such as stocks, funds, exchange-traded products (ETPs) or bonds.

The universe of potential investment choices is vast, so in this issue of Shares we’ve pulled together the key selections into handy groups. We discuss how to select an appropriate income-paying asset, the risks to consider and pointers on how to manage the more complicated side of dividend tax.

Income is one of the most important factors when investors decide which stocks, funds, ETPs or bonds to back. But there’s no guarantee you’ll get regular cash payments (with the exception of bonds, to a point, where the key risk is corporate default), and that’s why the potential rewards tend to be greater than cash ISA (Individual Savings Accounts) to compensate for the risk of putting your money into the stock market.

Model portfolio

We’ve looked at lots of different areas of the market in this article to help build a model portfolio consisting of nine income plays: A2D Funding 4.75% Dec 2022 (A2D1:ORB), Blackrock Continental European (GB00B3S9LG25), British Sky Broadcasting (BSY), Central Asia Metals (CAML:AIM), KCOM (KCOM), Old Mutual (OML), Personal (PGH:AIM), Securities Trust of Scotland (STS) and SPRD S&P UK Dividend Aristocrat (UKDV).

It is fair to say that investment income - which comes either as dividends or bond coupons payable generally every six months - can be viewed as free money to pay the boring stuff like the council tax or home insurance, thereby freeing up more cash from your salary to spend as you wish. You could put that spare money to work through investing in more assets, perhaps saving up to fund your child or grandchild’s education in the future or pay for the holiday of a lifetime.

US blogger Jason Fieber is a shining example of the potential rewards to be had from putting money into the market. The 32-year old invests in high-quality companies that have lengthy histories of paying and raising dividends. His goal is to retire before turning 40, live frugally supported by dividend income that funds day-to-day expenses without having to sell the underlying equities. In 2010, he generated $269.33 income from his investments. A year later that grew to $1,202. By 2013, dividend income netted the blogger $3,926 and the amount keeps rising. You can monitor his progress at www.dividendmantra.com.

Fieber’s portfolio presently consists of 47 stocks that cost $127,593 to acquire and was worth $162,809 at the start of June, excluding dividend payments to date. Converting that into sterling, this represents a portfolio purchase cost circa £75,000. Assuming a 5% average dividend, investors with a similar holding should expect £3,750 annual income.

The figures become even more interesting when you look at the projections for holding that stock for 10 years. A portfolio worth £75,000, averaging 5% dividend yield, growing the dividend by 8% each year, the share price rising by 7% each year, over 10 years will give you this result:

Without dividend reinvestment:

Total value: £206,208.96

Dividend payout value: £58,672.61

Annualised return: 10.6%

With dividend reinvestment:

Total value: £246,442.66

Annualised return: 12.6%

Source: Buyupside.com calculator

From this example you’ll see that dividend reinvestment can give you a much greater return, but the downside is that you won’t have any cash dripping into your bank account over those 10 years. A single share in Coca-Cola Company (KO:NYSE) bought at flotation in 1919 for $40 turned into an asset worth $10.3 million by 2012, assuming all dividends were reinvested annually.

Choosing dividend reinvestment or straight cash collection each time will depend on your personal circumstances.

It’s clear that value can be generated through either holding shares for a long period and pocketing dividends or reinvesting, so how do you go about picking the right investment?

For individual equities, you have to spot a company that is generating adequate cash to pay a dividend; that this payout is sustainable (and can rise each year); and you need to know there’s no major risks that could result in a hefty capital loss, thereby destroying your initial investment which you may need to turn into cash in the future.

With funds, you can be sure that the fund manager will have done a lot of this homework, hence why this could be a lower risk way of getting exposure to income-generating assets. Yet there will be extra costs (to pay the fund manager for doing the work) built into the product.

Exchange traded funds track the performance of a basket of stocks, typically based on a specific stock index, sector or investment style. Choosing bonds is down to your faith in the company not going bust before the end of the payment term, which is typically five to 10 years.

Positive signs

Paying dividends is generally the sign of a good company. It shows someone that is generating cash above and beyond what is needed to reinvest in the business.

Dividends are paid out of the cash position. It is important to see a company regularly generates new cash to fund the dividend and that it is not being paid out of retained earnings. After all, the latter technique is effectively paying out cash from your piggy bank. One day there won’t be any money left for shareholders, unless new cash goes into the pot.

That’s why you need to pay very close attention to the dividend cover. This is a measure of the affordability of a company’s dividend.

Dividend cover = Earnings per share ÷ Dividend per share

The higher the cover, the more flexibility the company has to pay the dividend, and potentially grow that dividend in the future if cash generation is good enough. As a rule of thumb, we look for a minimum dividend cover of 2 - or 1.5 if it is a utility company, as they benefit from long-term steady income through regulated activities.

There are risks with using the earnings per share (EPS) figure, nonetheless, as this can be manipulated. For example, management bonus payments are often triggered by hitting a certain EPS targets. There’s often accounting manipulation of earnings or sales recognition so that the required EPS is achieved. Yet these earnings won’t flow through into cash. And remember it is cash that’s needed to fund the dividend.

In his book Making the Right Investment Decisions: How to Analyse Companies and Value Shares, author Michael Cahill says you also need to look at companies where a significant portion of profit comes from related business - namely where the quoted company has an investment in another company or venture. ‘The former may book its fair share of profit but this will not necessarily correspond to the cash,’ writes Cahill, ‘as the cash received will depend on the dividend received from such investments.’

You also have to consider business risk and financial risk. If there are problems in a company’s end market, such as a price war or end-customers having issues which delay contract decisions, then earnings may fall. That could trigger a reduction in cash generation and profits.

If the business has lots of debts, its interest cover (operating profit divided by interest payments on debt) may fall below the safety level desired by its lenders. That could see it breach banking covenants and require a rights issue or asset disposal to raise new cash to address debt. In such circumstances the dividend is either cut or not paid at all. Just look at troubled outsourcing group Serco (SRP) which had to undertake a large placing to shore up its balance sheet earlier this year after a set-back in trading. Analysts quickly took their red pens to the dividend forecast.

Dividend paying sectors

Most industries pay a dividend, but notable exceptions are the junior ends of the technology, mining, oil and gas and biotechnology sectors. These tend to burn rather than generate cash, either spending money on research and development or exploration. On the latter point, it can take a year between making an initial discovery to bringing a mining project into production. Even once a project starts to generate revenue, there’s a high chance that cashflow will be redirected into expanding operations.

Many firms don’t pay a dividend if trading conditions have been tough or if the cash can be used more effectively in the development of the business.

Technology companies often have a ‘buy and build’ strategy, so cash is required for acquisitions. Investors shouldn’t feel they are being hard done by the absence of dividends. Increasing the size of a company through mergers and takeovers can generate shareholder value in time, although there’s inherent risk with over-paying for companies and integration into the existing operations.

Growth for growth’s sake is certainly why mining companies, in general, were absent from the dividend list - until recently. With commodity prices having fallen from their highs and the market having lost faith in the resources sector, miners are now having to resort to paying dividends in order to attract investors.

Shareholders are effectively being paid to wait for the next upwards swing in the commodity price cycle. But are 4% yields generous enough to compensate for the inherent risk that hangs over the sector? You need to be really bullish on the future of the commodities market to want to buy miners at present.

Miners have declared capital expenditure will start to fall, thus free cashflow levels should increase. But many of the big miners have large exposure to iron ore where selling prices have been very weak. That raises the risk of earnings downgrades and potential reduction in cash generation, thus fewer funds to deliver the much-hyped progressive dividend policy. We do see opportunities in the sector, but if you don’t have an appetite for risk then stick with the more robust sectors.

The selection process

Once you are ready to start looking for dividend opportunities, a good starting point is to run a stock screening exercise. Many financial websites or software providers offer easy-to-use programmes where you can filter for certain criteria. Relevant providers include Moneyam.com, Digital Look, Thomson Reuters Datastream and ShareScope. Some are free to use; others are subscription-based models.

Select the entire range of London-listed companies (Main Market and AIM) and make sure you display current share price, forecast EPS and DPS (dividend per share) numbers per stock. Export that information into a spreadsheet and work out the dividend cover (EPS divided by DPS). Sort the results by dividend cover and strip out anything below 1.5. If the stock screener hasn’t displayed the prospective dividend yield, work out that via the spreadsheet calculator.

Prospective dividend yield = (Prospective DPS ÷ Latest share price) x 100

Next you need to research stocks from your filtered list, principally looking at business and financial risks. To help with your selection, we’ve done the homework on the dividend yield and cover filters across various stock groups: See page 22 for FTSE 100 companies; page 23 for mid caps; and page 24 for small caps. Later on in the feature we discuss the income options for funds, ETPs and bonds.

Although many of the tables feature the top-yielding stocks, you mustn’t base your investment decision purely on the yield percentage. Yes, a 5% dividend yield looks great versus a lowly 1% you’d probably get from a cash deposit account. But a 2% or 3% yielding-company could be even more attractive over time, if it is able to put through attractive increases in the dividend every year. If the 5% yielder doesn’t put through any increase in the dividend in the future, your cash payments would eventually lag inflation.