Four warning signs a dividend cut is on the cards

Vodafone cut its dividend yesterday (14 May) and other big FTSE 100 names may soon follow suit. Here are four warning signs to spot a dividend cut in advance. 

On the surface the outlook for dividend investors looks positive, with payments hitting a record high for the first three months of 2019.

According to the closely watched Dividend Monitor report from Link Asset Services, the amount paid by UK companies rose to £19.7 billion, which represents a year-on-year increase of 15.7%.

But a look under the bonnet reveals there are headwinds that investors need to bear in mind.

First, there has been a growing trend among companies to pay special dividends, which are not as dependable as normal dividends. Some are made as one-off payments, so they cannot be relied upon. In 2018, over 10% of firms listed on the FTSE 100 index made special dividend payments, totalling around £6 billion. This was the highest figure ever paid in special dividends.

Second, given the expected yield for the FTSE 100 in 2019 is 4.7%, there are a number of potential value traps – shares with considerably higher yields than the average for the index that may prove to be unsustainable. Our regularly updated article of the highest-yielding shares in the FTSE 100 keeps tabs on the firms offering the most generous payouts.   

Below we highlight some of the main warning signs that point to a dividend in danger, starting off with the dividend yield.

HIGH DIVIDEND YIELD 

A high dividend yield looks attractive on paper, but it should be treated with a healthy dose of scepticism. As share prices and yields have an inverse relationship, a high yield more often than not is a sign that a stock, for whatever reason, is out of favour.

It is therefore crucial to do some digging to check whether the yield on offer is sustainable. One of the first things to look for is the company's track record for paying dividends.

Although a stock that has historically been a generous payer should not be considered a sure bet for dividends continuing to roll in, those businesses that have patchy records or have historically been poor payers should set alarm bells ringing.

DIVIDEND COVER 

This is considered a key metric to assess whether a company is in a healthy position to distribute dividends. It is calculated by dividing earnings per share (EPS) by the dividend per share (DPS).

As a rule of thumb, a low dividend cover ratio – around one times or lower – suggests dividends are vulnerable, as the company is using most if not all of its profits to fund the dividend. A figure of two or more is viewed as comfortable because it is a sign the business is not over-distributing.

Those firms that do hand back more cash than they can afford risk damaging their longer-term growth prospects through lack of investment in the business.

DEBT LEVELS ON THE RISE 

Another warning sign is when the dividend is being funded out of debt. One way private investors can work this out is by looking at the free cash flow measure, which takes into account how much money a company has left over once all business expenses have been made, including interest on borrowings.

Those businesses that pay their dividends without resorting to borrowing will have a positive free cash flow figure.

But bear in mind that a negative score does not always mean the dividend is under threat. If money is borrowed cleverly and efficiently, the business will ultimately become more profitable.

RETURN ON CAPITAL EMPLOYED 

While there are many ways to assess the strength of a business, arguably one of the most useful is a measure called 'return on capital employed' (Roce), which can be calculated from a company's accounts. The Roce is the profit figure divided by the assets of the businesses.

Warren Buffett is a fan, describing the measure in 1979 as “the primary test of managerial economic performance”. Roce is considered more useful than the more familiar return on equity (Roe) measure, because Roce also factors in debt and other liabilities.

There's no golden rule that dictates what a good or bad figure is; instead, investors should look at whether the Roce is rising or falling versus its historical value for that company.

But Terry Smith, manager of the Money Observer Rated Fund Fundsmith Equity, does not consider investing in a company unless it can achieve a Roce of more than 15%.

DIVIDEND PLEDGES CAN BE BROKEN 

Finally, although a commitment from the management of a company to maintain a future dividend payment should in theory be seen as a positive, the reality is that there have been far too many broken promises over the years for investors to bank on such pledges being kept.

The latest example was Vodafone. Last November, new chief executive officer Nick Read pledged to maintain the payout, but yesterday (14 May) it was cut by 40%.

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