Investors need to conduct a full analysis of a company to truly understand its dividend. Gauging the company’s prospects, cash flow and debt will help comprehend how fit it is to pay its dividend. A company may look attractive because it pays a decent, reliable dividend, but that is no good if it has high levels of debt, forecasts weaker growth or its cash flow is coming under strain. Ultimately, finding a stock that pays generous dividends is easy, but finding one that is safe over the long term is harder.
Importantly, a company’s dividend should be compared to peers in its own sector, as some industries are more renowned for payouts than others.
Below is a list of key metrics investors can use to analyse a company’s dividend:
Dividend payout ratio
The dividend payout ratio shows how much of the company’s earnings are being paid as dividends. This can be measured by dividing the dividend per share by the earnings per share (EPS) over the same time period. Technically, the higher the dividend payout ratio the better as this demonstrates a bigger proportion of earnings are being returned to shareholders. However, investors should be aware that a very high dividend payout ratio also suggests the company has little wiggle room if it hits hard times without cutting or abandoning payouts. Similarly, a low payout ratio suggests a company is not distributing as much of its earnings to investors as other companies, but it does suggest there is more upside to future dividends going forward.
The dividend yield is calculated by dividing a company’s annual dividend by its share price, demonstrating the ratio between the two. This is primarily used to analyse the stock purely from a dividend perspective. So long as the dividend remains unchanged, the yield will fluctuate in line with the share price. This does mean it can be distorted by volatility in share prices (if a dividend-paying stock suffers a large fall in share price one day, then the yield will look abnormally high, and vice versa). Ultimately, this analyses the performance of the dividend in relation to the share price.
Dividend cover helps investors understand how sustainable a company’s dividend payments are. This is calculated by dividing a stock’s EPS by the dividend per share, which will show how many times the company could cover its dividend payout. For example, if a company booked EPS of 10p and paid a dividend of 2p, it would have a dividend cover of 5x, meaning it could pay that dividend five times out of its pool of earnings.
Free cash flow to equity
Free cash flow is a key metric that underpins a company’s ability to pay dividends. The free cash flow to equity ratio measures how much could have been returned to shareholders. It is measured by taking the company’s profit, adding net debt and then subtracting the liabilities and obligations – including capital expenditure, debt repayments and working capital. This will reveal how affordable the dividend is for the business. Ultimately, this is a similar metric to dividend cover as it shows the company’s ability to pay its dividend – shareholders at least want to see that a business is generating enough cash to fund payouts.
Net debt to EBITDA
This is measured by dividing the company’s net debt (total liabilities minus cash and cash equivalents) by its earnings before interest, tax, depreciation and amortisation (EBITDA). This shows a company’s ability to manage to its debt pile with its own earnings, which is important because if a company can’t afford its debt then it is hardly in a position to pay a dividend. Similarly, if it is comfortably on top of its debt then it has a greater ability to make payouts to investors. The lower the ratio the better, but it also worth tracking this metric over the longer term as it can flag if a company’s balance sheet is strengthening or weakening.
Dividend dates: important events for your calendar
There are four key dates to watch out regarding dividends. These apply to UK-listed stocks:
The day that the dividend payment is announced. This is often unveiled at the same time as results are released (whether that be quarterly, interims or annual), but some companies release separate announcements that solely concern the dividend. This is effectively confirmation of what the latest dividend will be, and therefore these announcements often affect share prices as the market reacts to the better or worse than expected payout. The subsequent dates are usually outlined when the dividend is announced.
The record date is extremely important for investors. Investors that are on a company’s shareholder register as of the record date will be entitled to dividends. If you held shares in a business when it announced the dividend but sold them before the record date, then you would not be entitled to that dividend. This is the date that the company establishes who will receive its latest payout. Share prices can find support in the days leading up to the record date as demand tends to be stronger as investors aim to purchase shares in order to secure the dividend.
The ex-dividend date is the day after the record date. The dividend has not yet been paid, but anyone who purchases shares in the business after the record date will not qualify for the payout. Going ex-dividend has a severe impact on share prices as they tend to decline to account for the cash that is to be taken out of the business to pay dividends. A share with a dividend attached is obviously worth more than one without a payout. If you buy shares in a business on or after the ex-dividend date then you will only be entitled to future payouts – so long as you are on the register on the record date next time around.
The payment date is the day the dividend is paid to investors that were on the register on the record date. This is when the cash officially leaves the business and is returned to investors, but the impact on share prices is usually minimal as the effect of the dividend has often been priced in by this point.
Dividend policies: providing certainty but no guarantees
Dividend policies help provide some clarity about shareholder returns, but they should not be taken as gospel. Although many stocks try their upmost to deliver what they have promised it is not uncommon for companies to rebase their dividend or abandon it altogether if it has become unsustainable after several years of hardship. Some companies have no choice after plugging funding shortfalls with debt, which is no way to fund shareholder returns over the long term. For many, a less generous but more reliable dividend is the more responsible option.
Companies adopt various types of dividend policies, some of which are more suitable for certain industries than others. The type of policy it installs also says a lot about a company’s confidence and focus. Committing to a progressive payout is a bullish sign that earnings will grow over forthcoming years. Regular or residual policies are considered more prudent and sensible choices, while stable policies are geared toward long-term growth and provide upside to payouts while limiting the downside.
Investors have several ways to analyse the dividend of a company but must incorporate this into a broader evaluation of its business. Understanding a stock’s dividend using a variety of ratios is important as this can play a big part in evaluating how best to maximise potential returns on your investment, but understanding the safety and sustainability of the dividend is just as important.