When building my investment portfolio, I have always been keen to include a selection of income stocks. This is in addition to the standard growth and value investments. My aim for this portion of the portfolio is to generate consistent passive income, which can compound considerably over the years.
The biggest misconception when it comes to selecting a good income-generating share is to focus on picking companies that offer the highest dividend. Instead, I like to look for companies that offer a reasonable dividend, normally in the region of 2-3%. The company should also have been paying this dividend consistently for over 20 years.
Sage Group
The first company on my list is Sage Group (LSE: SGE), a provider of accounting software. The company focuses primarily on the UK, USA, and Europe, and has been operating for almost 40 years.
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Sage has paid a dividend for 30 years and has grown that yield for the last 21 years. It currently offers a dividend of 2.6%, which — although not the highest in the index — is still a fair return if delivered consistently.
The underlying fundamentals of Sage are also strong, with significant cash flow generation and considerable profit margins. However, it’s important to note that despite the share price falling almost 19% this year, it’s still trading at a price-to-earnings (P/E) ratio of 30.3. This is very high in the current market. Indeed, it could indicate that the company is potentially overvalued despite its quality fundamentals.
Nonetheless, I believe that the opportunity to access such a consistent dividend yield is worth paying a premium for. Therefore I would add Sage Group to the income stock section of my portfolio.
Diploma
The second company on my list is Diploma (LSE: DPLM), an industrial product supplier based in the UK. The company currently offers a dividend yield of 1.9%, although this is forecast to increase to 2.2% next year.
Diploma has also paid a dividend consistently for 30 years. The company has grown its yield for over 20 years. This level of consistency is why I would still consider the company a good income-generating share, despite the yield being lower than many of the typical examples of dividend-focused investments.
Furthermore, the company has very encouraging underlying fundamentals. It has significant cash generation, high forecast earnings growth, and a respectable level of earnings efficiency on invested capital.
That being said, the company is currently trading at a P/E ratio of 26.1. This is above the FTSE 250 average P/E ratio of 22 over the last 30 years. It is also worth mentioning that the current yield of 1.9% is considerably below the average FTSE 250 yield of 3.5%. This could indicate that the company may be overvalued. Furthermore, this increases the risks of share price declines over the next few years, potentially offsetting any income generated.
Despite this, I do consider Diploma to be a good income investment opportunity, as its consistent and growing dividend yield is worth paying a premium for. Therefore, I would add the company to my portfolio.
