Dividends can be a great way for companies to return profits to shareholders. For investors, they can be a powerful tool for growing your wealth.
But as we often say, no dividends are guaranteed. The real challenge is finding companies that can afford to keep paying a healthy dividend yield.
When looking at whether a company can afford to keep paying its dividend, there are three key checks we like to use – profits, cash, and history.
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income they produce will rise and fall in value, so you could get back less than you invest.
Dividend cover – a check on profits
We're looking at how much of a company's profits, or cash, it's paying out as a dividend – often referred to as 'dividend cover'. A dividend that's well covered means the company has enough cash or profits to fund the dividend – although that doesn't mean the dividend's guaranteed.
Profit is often where investors start when looking at whether a company can afford to pay its dividend. It's readily available information, making it a quick sense check.
To calculate the dividend cover, divide 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, the bigger the 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, rarely good news for any investor.
Checking if profits are enough to pay the dividend is a wise move. But it's not enough on its own.
Free cash cover – cash is king
Cash keeps businesses running, it pays bills, it pays employees and, most of the time, 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’s funded new investments, whether for international expansion or maintenance. This is known as 'free cash'. It's the cash actually available to pay dividends.
Free cash = cash from operating activities - capital expenditure
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 shows the business generated enough free cash to pay the dividend this year. Like before, a higher number is better.
As with any financial metric, we get the most value when comparing the results to both competitors and the company's history. Ratios are never as valuable in isolation.
Looking at the history
History doesn't always repeat itself, but it can tell a story.
It's always worth looking back at a company's dividend history. It's not a guarantee, but it gives an extra level of insight. After all, we’ll get most out of compounding dividends over time if they’re regular and stable (or growing).
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. Hint – lockdowns, the 08/09 financial crisis etc.
And look at the wider industry too. If a company can hold or grow its dividend when others are struggling, that tends to be a good sign.
We've just brushed the surface here – but these three principles give a good amount of insight. The harsh reality is no dividends can ever be guaranteed and past performance isn’t a guide to the future.