When investing for dividends, it's important to look beyond a company's headline yield and examine factors such as dividend sustainability and growth rates. The best dividend-paying companies are those which can comfortably cover their dividend payouts with earnings, and consistently increase their dividends year after year. With that in mind, here's a look at two dividend-paying banking stocks - one that I wouldn't buy right now and one that I would.
At face value, HSBC's (LSE: HSBA) dividend yield of 5.2% looks attractive. After all, that's a considerably higher rate than most savings accounts pay out these days. However, a little research into that high yield suggests that HSBC's dividend is perhaps not as attractive as it looks. Here's why.
Over the last four years, HSBC has paid out dividends of 49 cents, 50 cents, 51 cents and 51 cents, equating to a poor compound annual growth rate (CAGR) of just 1.3% per year. With inflation running at a level considerably higher than that, it means income investors are effectively losing purchasing power over time.
Is HSBC likely to increase its dividend in the near future? Not any time soon, according to this statement from the bank's website: "In the current uncertain environment we plan to sustain the dividend at its current level for the foreseeable future. Growing our dividend in the future depends on the overall profitability of the Group, delivering further release of less efficiently deployed capital and meeting regulatory capital requirements in a timely manner."
Clearly, a dividend that is frozen at a specific level for the "foreseeable future" is not ideal for the investor looking to build an income stream that rises over time.
Furthermore, with the bank generating earnings per share of just 7 cents last year, HSBC's dividend coverage ratio of 0.14 looks rather unhealthy. Earnings this year are expected to rise to 66 cents per share, but even then, dividend coverage will still only be a low 1.3 times.
For this reason, I'll be passing on HSBC's dividend now, and continuing my search for companies that offer healthy levels of dividend coverage and higher dividend growth prospects.
Close Brothers Group
One dividend stock that does look appealing at present, in my view, is UK-based merchant bank Close Brothers Group(LSE: CBG).
While its yield is lower than HSBC's at 3.7%, the payout looks considerably more sustainable, and has grown at a more impressive rate in recent years. Indeed, over the last four years, Close Brothers has paid out dividends of 44.5p, 49p, 53.5p and 57p, equating to a CAGR of a robust 8.6%. And City analysts forecast growth of 4.9% and 4.1% this year and next.
Furthermore, Close Brothers generated earnings of 128.4p per share last year, resulting in a healthy dividend coverage ratio of 2.3 times. That means the bank can comfortably afford its current payout, so there's less chance of a dividend cut.
Close Brother's valuation also looks appealing right now. While HSBC's share price has surged higher in recent months, Close Brothers' shares have done the opposite, falling from above 1,700p to 1,520p today. At that price, the bank trades on a forward looking P/E ratio of just 11.7 vs 15.0 for HSBC.
So weighing up the dividend growth rates, dividend coverage and valuation of both banks, Close Brothers certainly looks like the more secure dividend stock of the two, in my opinion.
Chasing high dividend yields is a common mistake
Chasing dividend yields that look too good to be true is a common mistake among novice investors. I've been there, done that, and suffered the consequences.
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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.