How to tell if your client’s dividends are safe

The recent fall in value of Pearson shares showed a company with skinny earnings cover for its dividend find itself forced to cut the shareholder payout, after a shortfall in profits in the current climate.

In 2017, as Donald Trump takes the reins of the US and the UK heads towards Brexit, it is certainly right for advisers with clients invested in company shares to be looking at dividend cover ratios and not get dazzled by headline yields.

A dividend coverage ratio indicates the capacity of an organisation to pay dividends out of profit attributable to the shareholders. 

For example, a dividend cover of three implies that a company has sufficient earnings to pay dividends amounting to three times of the present dividend payout during the period.

When a stock is trading with an unusually high yield, it often tells you that the market is unconvinced that the dividend is sustainable and may have to be cut. 

If your clients are going to invest in companies where the dividend cover is thin or even uncovered, you really need to be convinced that the near prospects for the business and its sector are going to markedly improve and that earnings will accelerate sufficiently to support the dividend.

FTAdviser asked an array of investment experts what lessons to learn from Pearson’s announcement last week and which FTSE 100 firms with fat yields could be next to cut their dividends.

Russ Mould, investment director at AJ Bell, said earnings cover should be assessed by advisers wishing to gather if a dividend is safe.

Earnings cover is calculated by dividing earnings per share by the dividend per share (usually on a prospective, or forecast, basis).

Ahead of Pearson’s announcement, the former owner of the Financial Times had in theory been offering a very tempting dividend yield of 6.4 per cent for 2017, based on a forecast dividend of 52p and the pre-collapse share price of 808p.

But dividend cover at Pearson was just 1.2 times – forecast earnings per share of 64p, per forecast dividend per share of 52p for 2017.

Ideally Mr Mould said dividend cover should be 2.0 times and the skinny 1.2 earnings cover ratio left Pearson with limited margin for error on its profit guidance.

Mr Mould said: “The 27 per cent drop in the share price wipes out six years of income at a stroke for anyone caught holding the stock.

“That is why there are few worse investments than an income stock which cuts its dividend, as the share price is likely to fall sharply, adding to the damage done by the loss of income.

Who could be next to cut?

Pearson was among the 10 highest forecast dividend yielding stocks in the FTSE 100 before it changed it’s outlook, so investors must do their homework to make sure that what look like juicy dividend yields are actually safe.

According to Mr Mould, based on consensus analysts’ forecasts for 2017 the aggregate dividend cover for the FTSE 100’s 10 highest yielding stocks now us just 1.3 times.

This is far less than ideal.

Investment experts FTAdviser spoke to pointed to the firm foundations of house builders’ yields.

Laith Khalaf, senior analyst at Hargreaves Lansdown, said several of the house builders are actually engaged in a programme of returning capital, which shows they are in relatively rude health.

He said: “While trading conditions may turn tougher this at least means they are entering any downturn from a position of strength.”

AJ Bell’s Mr Mould agreed that the house builders offer low cover but generally have net cash balance sheets and look safe enough in the near term. 

He said: “Any unexpected housing downturn could lead to difficult decisions. In a worst case scenario the builders could continue to easily fund their dividend yields by stopping buying land – but since the secret to their model is buying land cheaply at the bottom of the cycle, this may not happen so dividends could still in theory be sacrificed in favour of long-term financial gain, if the industry hits an unexpected rough patch.”

He said the non-life insurers could be the (nasty) surprise on the list. 

While lots of questions are asked about the others, no-one ever seems to question whether Direct Line and Admiral’s 7 per cent-plus dividend yield are safe, even though earnings cover is scanty at just over or just below 1.0 times.

Mr Mould said if there is to be a nasty surprise from left field perhaps it will come from one of these two. 

He said: “Direct Line’s full-year results are due on 28 February and Admiral’s full-year results are due 1 March. 

“Sterling’s fall will be pressuring car parts costs and lower oil prices could encourage more driving (and thus more accidents) while a government review due from the Lord Chancellor on 31 January could review the formula used to calculate compensation in serious injury claims. 

“There are suggestions Elizabeth Truss may cut the so-called Ogden rate and oblige car insurers to hold more cash on the balance sheet to meet their liabilities, thus reducing the amount of spare liquidity they can use to pay dividends.”

Who offers the best dividend cover?

More than 40 FTSE 100 firms do offer dividends cover above the 2.0 times mark which, in theory, offers some protection to the shareholder pay-out in the event of an unexpected event or profit disappointment.

The table below shows the 10 highest yields amongst those with the best dividend cover.

In terms of who is likely to maintain, pay a greater amount or cut dividends, Hargreaves Lansdown’s Mr Khalaf said: “Pressure is likely to build on airline groups and retailers from lower sterling, which could in turn affect their ability to pay dividends. 

“The oil majors are so far just about managing to hold things together but their fate is tied up with the oil price. If that takes another dive, the pressure on the dividend ramps up.”

Tilney Bestinvest’s Mr Hollands said there has been a sharp recovery in oil prices since their nadir in the first half of 2016 and more optimism as a result of the recent Opec orchestrated deal to cut production. 

He said while he was far from bullish on oil, the outlook is a certainly more stable now and demand and supply is expected to rebalance mid way through the year. 

Mr Hollands said: “With a better outlook, the risks of dividend cuts have abated to some degree and furthermore, payments for UK investors will surge as a result of their predominantly dollar earnings being translated into the weaker pound. 

“Shell however has increased its debt to funds its acquisition of BG Group, so I think this has put some further doubt into whether it should keep churning out such large dividends while servicing those debt costs.”

Ultimately Hargreaves Lansdown’s Mr Khalaf said investing in a company based purely on its yield is a recipe for disaster, and you need to take into account the prospects for the dividend to be maintained and indeed increased. 

He said dividend cover is one measure to look at, as is the expected profitability of the company going forward. 

Darius McDermott, managing director of Chelsea Financial Services, said while investors should be looking at dividend cover they also need to look below the surface and always think about the type of company. 

Mr McDermott said: “If a company dividend is 6 to 7 per cent there is usually a reason why (think of the banks in 2007).” 

He said: “We encourage investors to look for companies (and therefore funds) with lower but consistently growing dividends instead.”

Another point our experts felt was worth making is that because debt has been so cheap in recent years, some companies have paid dividends from debt rather than earnings. 

Chelsea Financial Services’ Mr McDermott said this approach to paying dividends can't go on forever. 

He said: “Many FTSE 100 dollar earners have been given breathing space since the pound fell post-European Union referendum, but their dividend cover previous to this was under a lot of scrutiny.” 

emma.hughes@ft.com