Investing for income – 3 ways to check if a dividend’s sustainable

Last week we highlighted the power of dividends for growing your wealth.

The challenge is finding companies offering a healthy dividend yield which can afford to keep paying it.

Here are a few things we look for when hunting dividend payers.

This article is not personal advice. If you're not sure whether an investment is right for you, please seek advice. All investments and income can fall as well as rise in value so you could make a loss. Yields are variable and not a reliable indicator of future returns.

Can the company afford its dividends?

When looking at whether a company can afford to pay its dividend, we make two checks – one looks at a company’s profits and the other at its cash.

We’re looking at how much of a company’s profits, or cash, it’s paying out as a dividend. You’ll often hear it referred to as ‘dividend cover’. A dividend that’s well covered means the company has enough cash or profits to pay the dividend - although that doesn’t mean the dividend’s guaranteed.

Dividend cover – a check on profits

Profit is often where investors start when looking at whether a company can afford to pay its dividend. It’s a readily available number and that makes it a quick sense check.

We do this by calculating dividend cover which divides profit per share by the dividend per share.

Dividend Cover = Earnings per share / Dividend per share

A ‘good’ level of cover will vary between sectors, but generally bigger is better.

A dividend cover of 1 shows that this year’s profits just covered the dividend. Put another way, the company paid out all this year’s profit as a dividend. That doesn’t leave much of a buffer if profits go south.

A dividend cover of less than 1 means this year’s profits weren’t enough to cover the dividend. That isn’t sustainable for long. It could mean a dividend cut is on the cards, not good news for those investing for the dividend.

Checking if profits are enough to pay the dividend is a good sense check. But it’s not really enough on its own.

Free cash cover – cash is king

Cash keeps businesses running – it pays electricity bills and employees. And it’s cash that’s paid out in a dividend.

As shareholders we’re interested in the pounds and pence a business generates from its day-to-day operations after it has funded new investments, whether that be for international expansion or for maintenance. This is known as ‘free cash’. It’s the cash actually available to pay our dividend.

Free cash = Cash from operating activities - Capital investment

Like dividend cover, we’re interested in whether the amount of free cash covers the total dividend to be paid that year.

Free cash cover = Free cash / Total Dividend

A result above 1 indicates the business generated enough cash to pay the dividend this year. Like before, the higher the number the better, but we must always compare a result to its competitors and it should be remembered ratios should not be looked at in isolation.

Track record

Last time we looked at the power of compounding and how reinvesting dividends can make a dramatic difference to the size of your investment over time, although of course there are no guarantees.

You may decide to look at companies that have shown the ability to pay a dividend over several years and what happened during those years.

Profits can take a hit when the economy goes through a bad patch, and you should be interested in what happened to the dividend during those years. If a company can hold or grow its dividend when others are struggling that could be a sign that it’s a defensive rather than cyclical business – and more able to weather economic downturns and in theory maintain the dividend.

In reality past performance is not a guide to the future and dividends may at some stage be inevitably cut regardless of how well it’s done in recent years.

Next up – putting theory into practice

No test should ever be used on its own, it’s best to use it in combination with others so we can build a clearer picture.

In the next article we’ll be putting these tests into practice on the UK stock market. Sign up to our weekly Share Insight below and we’ll send you a copy.

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