Not all dividend shares are the identical and buyers on the lookout for passive earnings must look previous preliminary appearances. However they can provide themselves the perfect likelihood by avoiding some vital miscalculations.

Mistake 1: forgetting the place the dividend comes from

It’s simple to really feel richer when dividend funds arrive. However buyers shouldn’t neglect that dividends are paid from a agency’s money.

For instance, when Video games Workshop (LSE:GAW) paid its buyers a dividend final month, they obtained 85p per share. However the firm they personal fairness in has given away precisely that quantity.

Which means buyers who see themselves as house owners of a enterprise – as Warren Buffett says they must – shouldn’t suppose they’ve obtained richer. All they’ve accomplished is liquidate a part of the asset they personal.

Video games Workshop has been an impressive passive earnings funding. The recognition of its Warhammer merchandise has allowed it to develop its dividend impressively over time.

In every case, nonetheless, the agency’s money decreases by the quantity it distributes. So receiving a dividend doesn’t make buyers richer – it simply transfers money from an asset they personal to their account.

After all, buyers can reinvest their dividends to spice up their possession of the corporate. However they’ll should pay Stamp Obligation on it, which implies they’ll get barely much less in inventory than they’d in money.

Proudly owning Video games Workshop shares has been an effective way of constructing wealth over the past decade. However it’s because its earnings have grown by over 1,000%, not as a result of it has paid these out to buyers.

Mistake 2: overemphasising dividend protection

The dividend protection ratio measures how a lot of a agency’s internet earnings it pays out to buyers. Strictly, the method is: (internet earnings – most well-liked dividends) ÷ dividends paid. 

Traders usually use this to attempt to gauge how sustainable an organization’s distributions are. However it may be extremely deceptive.

During the last 10 years, Video games Workshop has distributed over 75% of its internet earnings to shareholders. However the firm’s low reinvestment necessities imply it will probably return most of its income to buyers. 

That’s to not say the dividend is assured – shopper spending in a recession is a continuing danger for the enterprise and this might weigh on distributions. However any money it does generate may be distributed.

Against this, shareholder distributions from Pennon Group have accounted for lower than half of the agency’s internet earnings. However it might be a mistake to suppose this implies the dividend is much less susceptible.

The water utility has quite a lot of infrastructure to take care of and this requires quite a lot of money. In consequence, there’s a giant hole between the earnings it reviews and what it will probably return to buyers. 

Traders subsequently must keep away from considering that wanting on the dividend protection ratio is all there’s to understanding how strong a dividend is. It may be a helpful metric, nevertheless it will also be extremely deceptive.

Warren Buffett

Each of the errors above are ones Buffett has highlighted for buyers. The Berkshire Hathaway CEO attributes the success of his agency’s funding in Coca-Cola to its development, not its dividend.

Equally, Buffett places the success of Apple down to the corporate’s low capital necessities. Dividend buyers who observe these won’t handle the identical return, however they offer themselves the perfect likelihood.