Investors start to look out for potential dividend cuts (and a four-step check list on how to spot them)

The decision by both FTSE 250 member William Hill and AIM-quoted Shoe Zone to defer their dividend payments amid a downturn on trading may embolden other management teams who were considering this to take the difficult if potentially necessary decision. On paper the FTSE 100 is now offering a forward dividend yield of 6.5%, which looks like picking money up in the street when returns on cash are near zero and falling, and the 10-year Gilt yield is 0.51%. But earnings cover of 1.68 times was thinner than ideal before the viral outbreak knocked the global economy and a slowdown or downturn will leave many dividends exposed and at risk of a cut, so that yield figure could prove to be deceptive.

At least the stock market’s March plummet is pricing in a lot of dividend cuts (or in a best case deferrals) but income-seekers will still want to check their portfolios and assess which, if any, dividends in their portfolio are at risk.

There are four rigorous mathematical tests that investors can apply to check the degree to which a forecast dividend payment may be safe (see 'Dividends explained' below for a more detailed explanation):

• Dividend cover, according to earnings, ideally based on a mid-cycle or 10-year average for earnings, not forward one-year forecasts (as those forecasts are likely to be too optimistic in the current environment). The ideal amount of cover is 2.00 times or higher.
• Dividend cover, according to free cash flow (again ideally based on a 10-year average, not last year’s or this year’s forecast figures). The ideal amount of cover is 2.00 times or higher.
• Interest cover and net debt. The higher the cover (again 2.00 times or higher) and the lower the debt or higher the net cash pile, the safer the dividend may be.
• The size of the pension deficit or surplus. A deficit could further strain corporate cash flows, especially as the plunge in both share prices and Government bond yields mean that funding gap is likely to have increased in the past couple of months.

Beyond that, anything that looks too good to be true probably is in the current circumstances, although in these cases even a deferral or a swingeing cut to the dividend could still mean the stock offers an attractive yield once the bad news is out.

What will be interesting to see is whether CEOs and boards choose this moment to rebase their dividends. That 1.68 times forecast earnings cover for 2020 suggests that FTSE 100 firms are over-distributing, perhaps to curry favour with income-hungry investors, and they may take the feared economic setback as a chance to reset pay-out expectations, so they can better balance the need for investment in the business, the desire to pay down debt and the requirements of the pension fund with the demands of shareholders.

Ten highest yielding FTSE 100 stocks, 2020E

Source: Sharecast, consensus analysts’ forecasts, Refinitiv data

FTSE 100: ten biggest dividend payers, 2020E

Source: Sharecast, consensus analysts’ forecasts, Refinitiv data

The good news is that 50 FTSE 100 firms currently offer earnings cover of 2.00 times or more, which is traditionally seen as the mark that offers some sort of buffer in the event of a downturn in trading. However, Compass’ profit warning today means that its earnings will now undershoot forecasts so cover will fall and earnings profit estimates at other firms are going to start coming down very quickly as analysts get to work – Carnival, IAG and easyJet are just three firms where estimates are going to be slashed.

If there is a recession, then commodity prices are likely to weaken and that would put miners’ profits under pressure, although they have at least cleaned up their balance sheets in the past few years, and the banks may have to rein in dividend growth plans too, if loan books start to sour and interest rate cuts further pressure their net interest margins.

50 FTSE 100 stocks offer earnings cover in excess of 2.00 times for 2020E*

Source: Sharecast, consensus analysts’ forecasts, Refinitiv data. *As of the close on Monday 16 March, so does not take into account Compass ‘profit warning of 17 March

Dividend checks explained

1. Dividend cover is calculated as follows and is expressed as a ratio:

Prospective earnings per share (EPS)
DIVIDED BY
prospective dividend per share (DPS)

Ideally cover should exceed 2.0. Anything below two needs to be watched and a ratio under 1.0 suggests danger – unless the firm is a Real Estate Investment Trust, obliged to pay out 90% of its earnings to maintain its tax status; it has fabulous free cash flow and a strong balance sheet; demand is relatively stable and insensitive to swings in the economy, which really means utilities and consumes staples (although the increasingly active role of the regulator must be watched here rather than the economic cycle).

If you really want to go the extra mile, don’t look at one year forward earnings and dividend forecasts.

First, look at the operating margin – a high return on sales will provide a better buffer than a low one, should anything unexpected go wrong.

Second, look at the average operating margin and average earnings per share over the last decade, to capture a full economic cycle, just to make sure you are not being lulled into a false sense of security by what are currently peak, or near-peak operating margins. If a firm held its dividend when operating margins hit their last trough that is a good sign.

2. Operating free cash flow cover adds extra reassurance, because it is cash that funds dividends – and there is another old saying here: “profits are a matter of opinion, cash is a matter of fact.”

An extreme example of this is Carillion which was profitable and in theory offering an 8%-plus dividend yield just before it went bust owing to weak cash flow D]. This can be calculated in the four-step process below. Quite simply the higher the figure the better, especially when taken as a percentage of sales or operating profit.

Net operating profit
MINUS tax
PLUS depreciation and amortisation
MINUS capital expenditure
MINUS increase in working capital.

The operating free cash flow number can then be measured against the actual total cash value of the annual dividend payment. (Companies publish how many shares they have in issue, so multiplying that figure by the value of the distribution will quantify the total cost in millions of pounds).

If free cash flow cover exceeds 2.0 then that is a good start though again it may be worth looking at where operating profit and operating margins are compared to prior cyclical highs and lows and the average over the last decade.

3. Net debt and interest cover

A badly-stretched balance sheet can jeopardise a dividend payout, 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 and lenders are paid so they do not pull the plug. One good measure of a firm's balance sheet is its gearing, or net debt/equity ratio. This is calculated as follows and expressed as a percentage:

Short-term borrowings PLUS long-term borrowings MINUS and cash equivalents
DIVIDED BY
Shareholders funds
MULTIPLIED BY 100

A positive figures shows the firm has net debt, a negative one net cash. Crudely put, the lower the ratio the stronger the balance sheet, though utilities and other firms will 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.

Investors can then add interest cover to the mix. This ratio is also a good litmus test of a group's financial soundness. It is calculated as

Operating income PLUS interest income
DIVIDED BY
interest expense.

The higher the ratio, the stronger firm's finances are. Anything below 1.5 times would be a worrying sign and question whether dividends can be paid if anything unexpected goes wrong, the economy turns down or management simply makes a mistake. Again, interest cover may be best judged based on a 10-year average operating profit figure, to try and adjust for any cyclical swings in earnings and the risk that 2020 estimates are too optimistic.

4. The final check involves the pension fund, not least as this is becoming a political as well as an economic issue, following, Carillion, BHS and other high-profile corporate failures.

The balance sheet in the accounts will show whether this is a surplus or a deficit. A surplus is a good sign, a deficit a bad one as that hole will need to be plugged at some stage. A big deficit could also have just got bigger given the stock market drop and fresh decreases in interest rates and Government bond yields.

Investors can then also look in the cash flow to see what pension contribution the firm is making each year and how it compares to the cash outlay on dividends, just to make sure management is not giving too much to investors and too little to its stakeholders and former staff, as that balance could one day have to change.

These articles are for information purposes only and are not a personal recommendation or advice.