UK shares are the go-to choice for many income investors because of their strong focus on dividends. The regular returns that dividends provide equate to a steady cash flow, making income easier to calculate.
Without dividends, investors must rely on selling stocks to gain access to funds. If the market is down, this could mean having to wait until a more opportune time.
Identifying dividend stocks
Consider the long-running and well-established British insurance company Legal & General (LSE: LGEN). It has been paying a dividend for over 25 years, with 16 consecutive years of growth at a rate of 13.3% a year.
Even during tough economic periods, it has maintained a solid commitment to its shareholders. This is why it is one of the most popular dividend stocks in the UK.
But the past few years have proven particularly difficult for the company. A big earnings drop in 2023 meant its dividend payout ratio reached 276% — a worryingly high level. This metric compares the amount paid out in dividends to earnings coming in, with 100% meaning they are equal.
That means it paid out almost three times its income in dividends in 2023. Clearly, that is unsustainable. Track record or not, if earnings do not improve, it risks having to cut dividends.
Fortunately, things may be looking up. In a trading update last month, the company said it’s on track to achieve its 2024 full-year targeted profit growth of 6-9%. The following day, Goldman Sachs upgraded its rating on the stock to a Buy.
Growth vs income stocks
Growth stocks also have their place when aiming for passive income. Employees with a steady income may prefer to grow their investment first before shifting it to dividend stocks later in life. In the same vein, early investors may choose to reinvest their dividends, thereby compounding the gains until retirement.
Both options have their benefits depending on the individual investor’s strategy. When considering the benefits of a well-diversified portfolio, it makes sense to include a mix of growth and income stocks. This can easily be rebalanced over time as priorities change.
Calculating returns
Consider £5,000 invested in a portfolio of UK dividend shares with an average yield of 6%. Since dividend stocks tend to have low growth, an investor might expect an average price appreciation of around 3% a year.
The table below outlines an example portfolio with those current averages.
| Stock | Yield | Annualised growth (10 years) |
|---|---|---|
| Legal & General | 9.0% | -0.7% |
| Aviva | 7.0% | 0.5% |
| Rio Tinto | 7.0% | 5.6% |
| London Metric Property | 6.1% | 1.8% |
| HSBC | 6.0% | 3.3% |
| BP | 6.0% | 0.7% |
| Segro | 4.0% | 6.4% |
| Admiral Group | 3.2% | 7.0% |
| AVERAGE | 6.0% | 3.1% |
Within 10 years, a £5k investment in such a portfolio could reach £28,700. A yield of 6% on that would return only £1,615 a year in dividends.
To achieve meaningful dividend income, regular contributions are necessary to build up the portfolio. With just £100 added each month, the pot could balloon to £91,000 in 20 years, paying dividends of £5,000 a year. After 30 years, the annual dividends could equate to over £1,000 a month.
The above example uses averages based on past performance which is not indicative of future results. However, it provides a rough estimate of what a beginner investor should consider in terms of time and contributions required.
This post was originally published on Motley Fool
