Four warning signs a dividend cut is on the cards

Pound symbol being cut with scissors

Since UK interest rates hit 0.5 per cent over seven years ago, the hunt for income has been relentless.

Income seekers were helped by the dividend boom between 2012 and 2014, as scores of UK companies reinstated their income payments after repairing the damage the financial crisis had inflicted on their balance sheets.

But since the start of 2015 dividend cuts have come thick and fast. Some big FTSE 100 names that were historically viewed as reliable income payers, such as Tesco, cut payments.  

As things stand today the dividend outlook initially paints a gloomy picture, with dividend cover (one of our four warnings signs below) slipping to its lowest level since 2009. According to The Share Centre the ratio has dropped from 0.97 times to 0.8 times over the past year, a decline of 18 per cent, due to the fact that companies have increased dividends, but failed to grow profits at the bottom line.

This is not the only headwind. Another concern is that dividends are being given an artificial boost by the weak pound. At face value the dividend outlook looks healthy, with the latest UK Dividend Monitor from Capita Asset Services noting that dividends for the first quarter of 2017 increased by 9.5 per cent compared with the same period in 2016, to £15.4 billion.

But when taking sterling’s weakness out of the equation, underlying dividends actually fell marginally.

Below we name some of the main warning signs that point to a dividend in danger.

HIGH DIVIDEND YIELD

A high dividend yield looks attractive on paper, but it is 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 been a generous payer in the past 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 be cause for 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 score - 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.

Helal Miah, research investment analyst from The Share Centre, says: 'Dividend cover is still weakening, and this will ring alarm bells for income investors, especially as the outlook for the UK economy is moderating.

'Consumer spending is down, manufacturing growth is slowing, and the housing market is slowing. For domestically orientated companies, especially those in the 250, this will impact sales and profits, and is likely to weigh on dividends.'  

So as things stand today, which firms look vulnerable? According to broker AJ Bell, which crunched the numbers to find the 10 highest-yielding shares in the FTSE 100, oil majors BP and Royal Dutch Shell has the lowest dividend cover scores, 0.82 times and 0.91 times.

Russ Mould, investment director at AJ Bell, adds: 'The dividend cover for the FTSE 100 as a whole is 1.63, which is less than ideal 2.0 but at least it is above 1.5 which is where real concerns start to kick in (see explanation of dividend cover in attached report).  However, worryingly the ten companies that are forecast to have the highest dividend yield in 2017 have an average dividend cover of less than this at 1.29, with only one of them over 1.5.'  

CompanyYield, 2017E (%)Earnings cover, 2017E (times)
Taylor Wimpey7.41.39
Barratt Developments71.45
Royal Dutch Shell6.80.91
Direct Line6.71.24
BP6.40.82
SSE6.31.25
Rio Tinto6.31.77
Centrica61.32
Legal and General5.91.44
HSBC5.71.28
Average 6.41.29
Source: AJ Bell. Dividend yield and dividend cover is forward looking based on analysts' expectations.

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 measure, because Roce also factors in debt and other liabilities.

There's no golden number 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 per cent.


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