Dividend cover is looking worryingly sparse going into next year, as figures from AJ Bell indicate some companies might struggle to maintain their payouts to shareholders during a bad year.
Companies use dividend cover to calculate whether it can afford to use its profits to pay shareholders.
The ideal cover should be two times earnings because it means profit is double the amount the company is paying out to shareholders.
However, according to AJ Bell’s latest Dividend Dashboard report, the average dividend cover for the FTSE 100 currently stands at 1.46 times earnings.
Russ Mould, investment director at AJ Bell, said dividend cover of around 1.5 is “less than ideal” because it means a company has less room for manoeuvre if profits fall in one year.
“A company will then need to decide whether to reduce its dividend, stop reinvesting in the business or take on more debt.”
This comes amid concerns from fund managers, including Standard Life Investment’s Thomas Moore, that companies are increasingly using debt to pay their dividends.
Dividend cover below 1 should ring alarm bells Russ MouldAccording to AJ Bell data, the ten companies expected to dish out the highest dividend yields next year have aggregate dividend cover of just 1.17 times.
| FTSE 100 top ten forecast dividend yields in 2017: | ||
| Forecast dividend yield 2017 | Forecast dividend cover in 2017 | |
| Taylor Wimpey | 8.20% | 1.21x |
| Direct Line | 7.40% | 1.11x |
| Barratt Developments | 7.20% | 1.50x |
| Royal Dutch Shell | 6.90% | 1.00x |
| Admiral Group | 6.70% | 0.93x |
| BP | 6.70% | 1.03x |
| Pearson | 6.60% | 1.23x |
| Persimmon | 6.40% | 1.68x |
| Vodafone | 6.20% | 0.59x |
| Legal and General | 6.20% | 1.40x |
| Average | 6.9% | 1.17 x |
There are also 26 firms in the FTSE 100 firms that are expected to have dividend cover of 1.5 times or less.
Mr Mould said it can be tempting to simply seek out the stocks that are forecast to pay the highest dividend yield, particularly with income being such an important consideration for many investors.
However, the investment director said it is important to also assess whether the dividend yield is sustainable by looking at dividend cover and whether the dividend is growing.
A high yield on paper is useless if it doesn’t manifest in reality Ben Seager-Scott“Dividend cover below 1 should ring alarm bells because it means the company is paying out more to shareholders than it makes in that year.
“This means it has to dip into cash reserves, sell assets or borrow money to maintain the payment,” he said, adding this is unlikely to be sustainable over the long term.
But Mr Mould said the good news is there are 17 FTSE 100 firms that are forecast to yield in excess of 3 per cent in 2017 that also have dividend cover of over 2.
The FTSE 100 is forecast to pay out £78.4bn in dividends next year, which is £4.6bn higher than 2016 predictions. This equates to a yield of 4.2 per cent.
Ben Seager-Scott, director of investment strategy and research at Tilney Bestinvest, said income in a low interest rate world has been a major theme for the past few years.
"Investors have been pushed ever further up the risk spectrum in order to maintain an income yield in line with what they may historically be used to," he said.
"This has meant a lot of focus and pressure on equity income, with most company boards reluctant to cut their dividend given the negative connotations, even as earnings have come under pressure."
Mr Seager-Scott said this highlights the importance of good stock picking, particularly when looking at the sustainability of the dividend and the underlying fundamental basis that is driving return.
"A high yield on paper is useless if it doesn’t manifest in reality, and it can often be a signal that the market expects a dividend cut."
katherine.denham@ft.com
