Four ways to test whether a dividend is safe or not

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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

The swingeing dividend cut from Talk Talk and BT’s decision to abandon its plan to increase its shareholder pay-out by 10% a year are both timely reminders to investors of the dangers of over-reaching for yield in a low-interest-rate world.

BT’s shares held up relatively well on the news, albeit in the wake of a near 30% slide over the past 12 months (during which time the FTSE 100 has risen by 20%).

Talk Talk’s stock took a hammering. That share price plunge shows there are few worse investments than an income stock which cuts its shareholder pay-out, as the injury of capital loss is added to the insult of the lower-than-hoped-for yield.

BT and Talk Talk have both performed poorly in the past 12 months

BT and Talk Talk have both performed poorly in the past 12 months

Source: Thomson Reuters Datastream

Income-hungry investors must therefore do their research if they are picking individual stocks in their quest for yield, to ensure the dividends are paid and their capital investment is safe.

One tried-and-tested method for assessing whether a dividend is safe or not was the old rule of thumb that any yield 1.5 times higher than the yield available on the 10-year UK Government bond, or Gilt, would prove too good to be true.

The problem here is that the current 10-year Gilt yield is just 1.19%, thanks in part to Quantitative Easing and the lingering legacy of the Great Financial Crisis – and so the old rule implies that any dividend yield above 1.8% should be treated with a degree of suspicion.

That knocks out four-fifths of the FTSE 100 and two-thirds of the FTSE 250, which hardly seems practical, so stock-pickers need to use a further series of tools to ensure their targeted dividend payments are safe.

The good news is there are four other tests that investors can apply.

1. Earnings cover

The first is earnings cover for the dividend. This is calculated as follows:

Forecast earnings per share (EPS) ÷ Forecast dividend per share (DPS)

This is expressed as a ratio and ideally cover should exceed 2.0 times.

Anything below 2.0 needs to be watched and a ratio under 1.0 suggests danger – unless the firms is a Real Estate Investment Trust, obliged to pay out 90% of its earnings to maintain its tax status, or it has fabulous free cash flow and a strong balance sheet or enjoys near-guaranteed demand (like a utility, for example).

2. Free cash flow cover

Operating free cash flow cover (OpFcF) digs deeper into the accounts and focuses on the cash that actually funds the dividend.
It helps the investor see whether the company is having to strain to fund the dividend and whether capital investment, for example, is being cut to maintain the payment.

If so, shareholders may be getting the short-term gain of the dividend at the long-term expense of the firm weakening its business and long-term competitive position through underinvestment.

That would ultimately compromise the company’s ability to earn, generate cash and, in the end, grow or maintain its dividend.

The first job is the calculate operating free cashflow (OpFcF) as:

Net operating profit - tax + depreciation and amortisation - capital expenditure - increase in working capital

Operating free cash flow cover for the dividend then is assessed as:

Operating free cash flow (OpFcF) ÷ The actual cash value of the dividend (number of shares in issue times forecast dividend per share)

Again, the higher the ratio the safer the dividend should be.

3. The balance sheet

Debt and cash on the balance sheet are important because if a company’s finances are badly stretched the dividend pay-out could be in jeopardy, since a heavily-indebted firm will have to pay interest on its liabilities and repay those obligations at some stage.

Ultimately a firm could have to reduce or pass its dividend to preserve cash and ensure its banks are paid.

One good measure of a firm's balance sheet is its gearing, or net debt/equity ratio. This is calculated as

Short-term borrowings + long-term borrowings + Pension liabilities - and cash equivalents ÷ Shareholders’ funds x 100

The result is expressed as a percentage.

A positive figures shows the firm has net debt, a negative one net cash.

Crudely put, the lower the gearing ratio (or the higher the cash ratio) the stronger the balance sheet, though utilities and other firms with relatively predictable cash flows will be able to carry higher debts more comfortably than cyclical firms, whose income swings around in a much less predictable manner.

4. Interest cover

Interest cover is a final valuable check on a company’s financial soundness. This is calculated as:

Operating income + interest income ÷ interest expense

The higher the ratio, the better and anything below 1.5 times is a worrying sign, with a ratio of 2.0 times or more the ideal result.

A score over 2.0 shows the company has a buffer, or margin of safety, in case of an unexpected downturn in trading or something going wrong.

A plunge in interest cover toward 1.0 times could force the company to choose between paying the dividend, investing in its core operations or paying its bills, a decision where the shareholder pay-out is likely to be first for the chop.

Screen test

Applying these screens to Talk Talk and BT before their dividend disappointments would have yielded the following results:

Screen tests questioned Talk Talk’s dividend and BT’s dividend growth potential

2017E dividend yield (%) Forecast dividend cover 2017E PE (x) OpFcF cover (x)   2016 Net debt/(cash) £m Historic Net debt/(cash) equity (%) Interest cover (x)
BT 4.9% 1.82 x 11.2 x 2.34 x 20,147.0 64.3% 4.7 x
Talk Talk 8.7% 0.53 x 21.7 x 0.21 x 699.0 302.6% 1.8 x

Source: Company accounts, Digital Look, consensus analysts’ forecasts. Based on Talk Talk share price at close on Tuesday 9 May and BT share price at close on Wednesday 10 May.

Talk Talk’s earnings and free cash flow cover were thin and its balance sheet less than pristine. Add that to the operational mis-steps suffered in 2015 with the security breach, and the fiercely competitive nature of the industry in which it operates (fighting BT, Sky, Vodafone and Virgin Media on several fronts at once) and the dividend was at risk.

In this case, it took a change of management and a strategic reset to bow to the inevitable.

BT’s earnings and free cash flow cover were better and the balance sheet stronger (although including 2015’s £6.4 billion pension deficit was important).

But its woes in Italy and at its Global Services arm, plus the escalation of the content rights bidding war with Sky, again put cash flow under pressure and raised the question of whether its dividend growth goal was ambitious, unless earnings growth suddenly accelerated.

Including the pension deficit in the net debt number added further rigour to the screening process as filling that gap will drain away cash that could otherwise go on the dividend or investment in the underlying operations.

High yielders

Investors now have the chance to reassess Talk Talk and BT on the basis of the new dividend guidance, actual 2016 results and revised analysts’ earnings forecasts for 2017 and beyond.

But income-seekers will also want to know whether there are any more dividend cuts or pay-out growth disappointments around the corner.

To save them some time, and show how the data can look, AJ Bell has therefore applied the four screen tests to the ten highest yielding stocks in the FTSE 350.

The FTSE 350’s ten highest yielding stocks confront the screen tests with varying degrees of success

2017E dividend yield (%)   Forecast dividend cover (x)  2017E PE (x) OpFcF cover (x)    2016 Net debt/(cash) £m Historic net debt/(cash) equity (%) Interest cover (x)  
1 Carillion 8.3% 1.83 x 6.6 x 2.23 x 1,029.5 141.0% 3.1 x
2 Redefine Int'l 7.6% 0.95 x 13.9 x -8.08 x 733.6 100.0% 2.4 x
3 Direct Line 7.5% 1.06 x 12.6 x 0.72 x  (571.2)  (22.7%) 8.4 x
4 Galliford Try 7.2% 1.58 x 8.8 x 1.49 x 13.0 2.2% 10.1 x
5 Royal Dutch Shell 6.9% 0.96 x 15.1 x 0.30 x 69,425.4 46.4% 2.6 x
6 BP 6.8% 0.91 x 16.1 x -1.07 x 34,675.4 45.3% -0.2 x
7 Taylor Wimpey 6.7% 1.38 x 10.8 x 1.10 x  (130.6)  (4.5%) 24.2 x
8 Phoenix Group 6.6% 0.86 x 17.5 x 0.11 x 1,050.0 31.5% 0.5 x
9 Debenhams 6.6% 1.93 x 7.9 x 3.21 x 289.5 32.8% 9.3 x
10 Petrofac 6.6% 1.68 x 9.1 x 2.71 x 489.7 54.9% 5.1 x

Source: Company accounts, Digital Look, consensus analysts’ forecasts

  • Carillion’s stretched balance sheet, which contains a large pension deficit for good measure, explains why so many hedge funds are bearish on (and short of) the stock, as its dividend yield looks “too good to be true”, rather like Talk Talk’s was before today’s cut.
    However, earnings cover is near two times and OpFcF cover is in excess of that so the support services business’ pay-out may be safer than it looks – but the sector is so badly littered with cost overruns and bungled projects that Carillion has more work to do before it convinces the doubters, especially as its operating margin is relatively thin at 4.5%.
  • BP and Shell fare poorly, too, but they can further disposals to come, have limited debt and are running efficiency programmes too. A sudden fall in the oil price would put them under greater pressure but in the view the best cure for low oil prices is low oil prices both Shell and BP probably have enough room for manoeuvre to see them through any 2-3 year downturn.
  • The other stock where the safety of the dividend is regularly questioned is Debenhams, not least because margins and profits have been trending lower. On the face of it dividend and OpFcF cover are acceptable but the long (off-balance sheet) leases on its stores may flatter how its finances look at first glance. Any signs that new boss Sergio Bucher’s strategic review is not bringing in additional profit will again put Debenhams’ dividend in the spotlight.

No short cuts

If this looks and sound like hard work – well, it is.

But there is no such thing as a free lunch and income-seekers must do this research before they put capital at risk and their strategy into place.

And if this looks or feels too time consuming or difficult, that is why fund managers exist and there is a wide selection of specialist income funds from which to choose.

They will do the job for investors, although the funds will charge fees in exchange for their time and expertise.

AJ Bell’s Favourite Funds list features a range of income funds, looking at stocks and bonds, at home in the UK and overseas.

You can find them at the link below, although you will still have to research them as well, to make sure the funds fit with your overall investment strategy, target returns, time horizon and appetite for risk.

youinvest.co.uk/investment-ideas/favourite

Russ Mould, AJ Bell Investment Director


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.