When Aussie sharemarket returns start to stumble it’s easy to get seduced by high-interest savings accounts and term deposits – but yanking your funds out of the sharemarket is not always the smartest option when better yields can be made on high dividend paying shares. The trick is tracking down the stocks set to pay high dividends now and in the future.

Buying stocks for dividend yield means that you don’t have to rely on share price gains to make money. This comes in rather handy during market sell-offs or flat-lining sharemarkets. Since dividends are paid out of a company’s profit, even if the share price falls, your dividends don’t.

So how can you track down the top dividend paying stocks? And just because a company pays fat dividends today, how do you know that it’ll continually pay juicy dividends in the future? There are a couple of tricks up our sleeve that we can use, but first up let’s figure out what we are looking for.

Many companies pay dividends to shareholders every six months – usually in April and October. After paying the costs of doing business – wages, equipment, interest on loans and other items – the company distributes a proportion of what’s left over (its profit) to shareholders in the form of a dividend. The company then reinvests any remaining profit for future growth.

Companies that pay dividends tend to be more established companies – often termed “blue chips”. These companies can be found across all sectors, such as banking, insurance and retail, and are less prevalent in speculative or new industries such as IT or biotechnology.

Financial commentators and analysts prefer to talk about the dividend yield rather than the straight dividend. That’s because the dividend yield lets them line companies up side by side as well comparing them against the overall sector. Analysts calculate the dividend yield by dividing the dividend by the share price and multiplying it by 100 to convert it to a percentage. Let’s use NAB as an example. The bank paid a dividend of $1.82 a share for the year ending 30 September 2007. Using a share price of $28, the calculation is:

NAB dividend yield = 182/2800 X 100 = 6.5%

The problem with this calculation is that it’s based on what NAB paid in dividends in the past (historic dividend yield) and not what it intends to pay out in the future (prospective dividend yield). Some analysts like to replace the historic dividend with a forecasted dividend in this calculation to gauge a company’s likelihood to pay dividends in the future.

So if the dividend yield is used to compare stocks, why don’t we just rush to the sharemarket tables in search of the highest dividend yielding stocks? Unfortunately, there are other factors that we need to take into consideration.

The denominator of the dividend yield calculation is the share price. In short, this means that when the share price falls, the dividend yield rises.

So if we run out finger down the list of highest dividend yielding stocks, we have to be aware of the fact that a company may have topped the charts due to a sagging share price. When a yield is rising, you have to ask why.

Indeed, it’s highly possible that a rising yield could be due to a falling share price. Investors might be selling down stock because they fear the company will not have enough future earnings to pay such dividends over coming years. In the current climate, especially, some investors may fear that company earnings have reached a peak.

So how can you safeguard against picking a high-yielding stock today that becomes a low-yielding stock tomorrow?

The answer lies in a ratio called the dividend cover, or times cover. This involves dividing the total earnings of the company by the total dividend payout for the year (interim plus final distributions). So if you run this basic calculation over your favourite stocks, you can interpret the results as follows:

    * > 1 – OK result. The company has earnings left over after paying the dividend.
    * > 2 – Good result. The dividend comprises less than half of the company’s earnings for the year.
    * < 1 – Not a good result. The company needs to draw on more than its earnings (such as previous years reserves) to pay its dividend.

If a company has a dividend cover of less than 1, you probably should view this as a warning sign that if the company hits tough times – or downgrades its earnings – it may be forced to slice dividends paid to shareholders.

As a rule of thumb, most analysts recommend looking for companies on a dividend cover of at least 1.3.

Therefore when looking down the list of the highest yielding stocks, be warned that a stock with a dividend cover of 1 – which therefore pays out its entire net profits as dividends – has little room to move if profits fall.

So back to our original point on comparing high-yielding stocks to high interest savings accounts and term deposits.

Investors can’t say, well, NAB pays a dividend yield of 6.5%, which is lower than I can receive on my internet savings account of 8% – so I might as well yank out my funds from the sharemarket and invest in cash. There are several reasons why this false thinking; firstly, NAB shares also entitle you to possible capital gains from share price rises over time; the second reason is that NAB shares also come with franking credits that reduce the after tax return.

Many blue chip companies offer fully or partially franked dividends, giving shareholders a tax rebate on the tax already paid by the company on its profits. This rebate is used to reduce or – depending upon your marginal tax rate – eliminate your tax liability altogether.

In sum, when choosing a high-yielding stock, the following points should be taken into consideration:

    * What is the dividend yield of the company and how does it compare to its peers and the overall sector?
    * How has the dividend yield altered over time, and if it is rising – is this due to a rising dividend per share or a falling share price?
    * What is the stock’s dividend cover, and what does this tell you about its ability to continue to meet its dividend obligations in the future?
    * Does the stock offer fully or partially franked dividends and how does this affect its after-tax return?
    * What is your overall view on the stock and its ability to post capital gains in the future?

The best way to access a list of high-yielding shares is to consult the financial tables published in the major newspapers. The ASX website includes a tool, enabling you to nominate 10 stocks at a time to receive information on current dividends.