Q.  A lot of dividends on good companies are higher than interest rates available either under Term Deposits or hybrid investments. Should I just go buy shares with high dividends for income in retirement? 

A.  According to Commsec, a record 91% of the 173 ASX listed companies who posted results for the six or twelve months to December 2015, declared a dividend. Commsec found that approximately 63% of companies increased dividends, 14% kept them steady, 14% reduced dividends and 9% didn’t declare one.

The dividend yield is the income return shareholders receive on a share.  Dividend yield is calculated by dividing the yearly company dividend by the current market price of the share.

The average dividend yield of the companies was 4.89% which is the highest since June 2009.  Furthermore almost 90% of those reporting results booked a profit at or near record levels.

Given this environment of rising dividends off the back of on or near record earnings, it would be very tempting to rely on the dividends from shares to provide regular income. In recent history companies that have delivered consistent dividends at attractive rates have been keenly sought by investors seeking to generate income.

Whilst dividend yield is one measure of the income return to shareholders, it is very important you understand that it is one of a number of measures that you need to consider when assessing the value of a share.

One of the most challenging aspects of relying on dividend yield is that it is a backwards looking measure.  Prior to buying any share with a high yield, you need understand why the company is paying such a high dividend and the likelihood that the company will be in a position to continue to pay at that rate.

The high dividend yield may be as a result of the share price falling.  When share prices fall, the dividend yield increases.  Remember the yield is calculated by dividing the dividend by the current share price.

Investing in shares with high yields and a falling share price is often referred to as a Dividend Trap.  Investors are attracted to the high yield but the high yield is a result of historic earnings and the outlook for the future earnings or growth of the company may have caused the share price to fall.

A high dividend yield may be cause for concern if  the dividend is a result of one off special dividends or capital distribution.  Often this is an admission by the company that they see no likely growth prospects for the company and therefore are returning earnings to shareholders.  There is nothing wrong with companies making additional and special distributions to shareholders provided shareholders do not expect this to be a long term phenomenon. Eventually the share price will be affected.

Companies may face pressure to maintain a dividend in order to avoid a fall in share price.  Companies may take on debt to fund dividends.  Pre Global Financial Crisis we saw this with Property Trusts that would pay dividends out of non-cash earnings such as a revaluation of a building.

The best way to check on the source of the earnings to pay a dividend is to check the free cash flow statements of a company to see how much actual cash was produced in the past twelve months.

The best way to check the future prospects for a dividend is to look at the forward earnings forecasts of the company, the track record of delivering stable consistent dividends and finally the outlook for the company and the sector that they operate within.

Follow Andrew on Twitter @AndrewHeavenFP. This article was originally published in The Australian