Page 45 - DIY Investor Magazine | Issue 33

‘A HIGH DIVIDEND YIELD MIGHT ALSO BE SIGNALING THAT IT IS SICK AND HAS A DEPRESSED SHARE PRICE’
DIVIDEND COVERAGE RATIO
When evaluating a company, consider whether the company can afford to pay the dividend; the ratio between its earnings and the dividend paid to shareholders—known as dividend coverage—is useful for measuring whether earnings are sufficient to cover dividend obligations.
The ratio is calculated as earnings per share divided by the dividend per share; when coverage is thin there is every chance of a dividend cut and the knock on effect to valuation.
A coverage ratio of 2 or 3 should provide comfort, but the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, whereafter prospects start to look risky.
A ratio below 1 means the company is using its retained earnings from last year to pay this year’s dividend.
If the payout gets very high, above 5, investors should ask whether management is paying enough cash to shareholders or withholding earnings; managers that raise dividends are telling investors that business will be stable over the coming 12 months or more.
DIVIDEND CUTS
If a company with a history of rising dividend payments suddenly cuts its payments, investors should be concerned that there is trouble ahead.
Whilst a history of steady or increasing dividends is reassuring, investors need to be wary of companies that rely on borrowings to finance those payments.
An example is the utility industry, which attracted investors with sizeable dividends and reliable earnings, but took on greater debt levels as they tried to maintain dividends, whilst diverting cash into expansion opportunities.
Investors should be wary of companies with debt-to-equity ratios greater than 60%, which can pressure its share price and in turn hamper a company’s ability to pay its dividend.
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DIY Investor Magazine · Apr 2022