A useful rule of thumb is that dividend yields of more than 6% indicate that the market is pricing the risk of a dividend cut.
The 6% threshold isn't cast in stone, but I've found it to be a useful tool when screening the market for possible buys.
In this article, I'll look at two stocks which each boast forecast yields of about 6.5%. Are these shares bargain buys at current levels, or is a storm approaching?
As safe as houses?
Housebuilder Galliford Try (LSE: GFRD) is also involved in public sector construction projects. This makes it an interesting alternative to conventional housebuilders.
The group's pre-tax profits rose by 19% to £63m during the six months to 31 December, despite a more modest 4% rise in sales. This lifted Galliford's return on net assets from 23.1% to 24.9%, which is impressively high.
The interim dividend rose by 23% to 32p, putting the firm on-track for a full-year payout of 94p. This equates to a yield of 6.2%. The company said that the increased payout reflects "confidence in the full year outlook".
However, the firm's profits will need to be significantly higher during the second half of the year. Galliford's H1 earnings of 61.9p per share are significantly less than half the 150.4p per share figure which analysts are forecasting for the year to 30 June.
Although Galliford's forecast P/E of 10 looks superficially cheap, the UK housing market is several years into a strong period of growth. Profit margins are very high at the moment. A housing slowdown could change out outlook dramatically. I'd rate Galliford Try as a hold at current levels, but I'm not sure this is the best time to buy.
This P/E of 8 is tempting
Highly-regarded fund manager Neil Woodford has stayed loyal to Capita (LSE: CPI) over the last year, despite the outsourcing group losing 53% of its value during that time.
The firm's problems are familiar. Bad contracts, rising costs and excess debt have put pressure on profit margins. These are similar problems to those which afflicted peers Serco and G4S. However, both of these firms are now well on the way to recovery. So does Capita offer us an opportunity to get in at ground level ahead of a strong turnaround?
Quite possibly. But a couple of risks remain. The first one is that Capita may yet face further contract problems. This firm has tried to address this with a contract review and a £50m write-off. But it will take a little longer before the market can be confident that the remainder of Capita's contracts are performing in line with expectations.
The other risk is debt. Management expects the firm's net debt to EBITDA ratio to have reached 2.9x by the end of last year. That quite high and is above the firm's target range of 2.0-2.5x. Capita hopes to sell its Asset Services division this year to raise cash and reduce debt. But there's no buyer as yet, so the firm could still be forced to ask shareholders for cash.
Capita shares trade on a forecast P/E of 8.2 with a yield of 6.3%. I think the price reflects the mix of risk and potential reward, so I'd hold for now.
This could be today's top income buy
Capita and Galliford Try may be of interest. But the Motley Fool's top analysts have identified an income stock which they believe could be significantly undervalued at current levels.
This company is a mid-cap UK business with activities in Europe. Progress has been solid in recent years and this group has also been suggested as a bid target.
Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.