British dividend shares have a reputation for being quite generous with shareholder payouts. The FTSE 100 is one of the world’s leading stock indices when it comes to yield. And by being more selective, it’s possible to build a robust portfolio generating close to a 6% income rate without taking on excessive levels of extra risk.
So let’s take a look at how investors can leverage these investments to start generating some extra cash.
High yield or high potential?
When building a portfolio of income-generating opportunities, a common go-to tactic is to focus only on high-yield stocks. So those targeting 6% or more may only consider shares providing payouts of at around this level, or higher.
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However, in my experience, this can be a crucial mistake. High-yield opportunities often come with more risk. There are obviously exceptions. But in many cases, dividends often get cut when delving into this region of the stock market.
Don’t forget that yield is driven by both shareholder payouts and share price. Sadly, it’s usually the latter dropping which causes yields to rise. And that can be a strong sign of a lack of confidence from investors that the underlying business can maintain payments.
Therefore, the strategy I prefer is to hunt down income-generating businesses with the potential to consistently grow free cash flow, regardless of yield. In my experience, these types of companies often end up consistently raising dividends. And over time, this can boost an initially unimpressive yield to potentially jaw-dropping levels.
An extreme example of this from my portfolio is Safestore. The self-storage enterprise has hiked its dividends so much that investors who originally bought shares in 2013 are now reaping a 50% return each year on their original cost basis!
Finding the ‘next’ Safestore
As previously mentioned, free cash flow is the metric that matters. While net income is often the point of focus, this number also includes non-cash earnings that can’t be used to fund shareholder payouts.
For example, a real estate company will include movements in the valuation of its property portfolio as a gain or loss as part of net income. This can lead to some crazy high levels of paper profitability (like we saw a few years ago). It can also mean massive levels of paper losses (like we’re seeing right now).
Free cash flow isn’t affected by these types of events. And by comparing it with the total amount of dividends paid, it’s possible to determine whether current dividends are affordable.
But what about future growth potential? This one can be a bit trickier to work out. There are a lot of moving parts that influence the success of a business. But one of the first places I like to start is looking at management strategy. This can be found in the annual reports.
Statements from the chairman and CEO can offer a powerful inside look at where the leadership thinks the business is going. From there, I can investigate how realistic the plan is and whether they’ve managed to hit their goals over the years.
