In the hunt for top quality dividend stocks, income investors frequently gravitate to the yield as a guide to how much bang-for-their-buck they are going to get. Unfortunately, while a heady yield can be a seductive signal of regular chunky returns it can also be a red flag for an imminent dividend cut. To tackle this problem, analysing Divided Cover – or the cushion of cash a company has after paying out shareholders – is a vital tool. But how much cover is enough – and how much is too much?
Dividend Cover has earned a reputation among investors and analysts as essentially a security metric. By dividing a company’s annual earnings per share by its dividend per share, you can get an idea of the ratio of profit that is being paid out versus what is being retained. Typically, Dividend Cover of 2x earnings or more is regarded as adequate (which would mean that the company is retaining as much cash as it is paying out). At 1x or less, the company is distributing all of its earnings as dividends or even dipping into reserves from previous years.
Dividend Health Check
In the ebbs and flows of investment commentary, the issue of Dividend Cover only really comes to the fore when a stock looks vulnerable. As a result, companies themselves will often refer to their preferred level of cover in their overall dividend policy, which tends to get discussed in preliminary results and annual reports. Because many companies are reluctant to cut payouts even if profit levels fall (for fear of upsetting investors), Dividend Cover is a useful indicator of earnings persistence and financial health, particularly when tracked over a period of years.
A good example of this occurred recently at retail group Mothercare (LON:MTC), which doubled its annual dividend from 9p to 18.3p between 2006 and 2011. That payout was generally well covered at between 1.6x and 2.7x over the period except last year when the Dividend Cover fell to 0.4x on a yield of 9.2 percent. Followers of the chain, which has struggled to perform in recent years, sensed problems ahead. They were right – Mothercare lost £103 million last year, forcing it to slash its 2012 dividend (to 2p) and suspend future payouts until its fortunes improve.
Hit the Sweet Spot
While Dividend Cover…
