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How to spot a dividend cut

Tom Stevenson

Tom Stevenson - Investment Director

If you invest via funds, then you can safely disregard the arithmetic of investment. That is one of the things you are paying a fund manager to do for you!

But knowing the basics about investment maths can give you more confidence as an investor. And don’t worry, it’s not all rocket science. Understanding some of the key ratios that professional and the most engaged private investors study is not difficult and can be enjoyable too.

how-spot-dividend-cut

One of the best indicators of value in the stock market is the dividend income that companies pay out to their investors. If dividends are high relative to share prices then, all other things being equal, the market or an individual share can be viewed as cheap. If the pay-out is low on this measure, then the market or share might be expensive.

The ratio of dividends to share prices is known as the dividend yield and calculating it is easy. Simply divide the dividend by the share price and multiply by 100. So, a company whose share price is 200p and which is paying a 10p per share dividend has a 5% dividend yield (10/200 x 100 = 5).

Today, the average member of the FTSE 100 index offers investors a 4.5% yield. That is higher than it has been for many years and is attractive when compared with the income available from other investments like cash or bonds.

It is one of the key reasons that I have turned positive on the UK stock market in my quarterly Investment Outlook.

Read the latest Investment Outlook.

The average dividend yield is, of course, just that - an average. In practice there are many FTSE 100 companies offering much higher dividend yields. When I looked just now, there were quite a few listed with yields of 5% or higher.

So, are all these companies cheap? Well some of them may be. But not necessarily - and this is where investors need to tread carefully.

A high dividend yield is telling you one of three things:

  • The first possibility is that the company is raising its dividend quickly and the stock market has not yet caught up with the good news. This is actually quite unlikely, because markets tend to anticipate good news or at the least respond to it very swiftly.
  • More likely, the dividend yield is high because the share price has fallen. As you can see from the simple sum I talked you through just now, a lower share price will result in a higher dividend yield.
  • The third possibility is that the dividend yield simply appears to be high because the company has been paying a high dividend in the past but is unlikely to continue doing so. In this case, investors will anticipate a cut in the pay-out and reduce the share price until it reaches a level at which the expected dividend represents an acceptable yield.

So, as an investor, you have to ask yourself a couple of key questions. First, is there a good reason why the share price has fallen? Second, how reliable is that dividend?

The second of these is the tricky one and it’s where income-focused investors tend to go wrong. They assume a company will continue to pay, or even better increase, the dividend. But the falling share price is telling them something else - that the pay-out is actually not sustainable.

So, before you invest in a company on the basis of its dividend yield, here are a couple of simple things you should look at:

  • First, make sure that there are enough profits out of which to pay the dividend. Check the latest results announcement to see that earnings per share are higher than dividends per share. To be really safe, you might want to see earnings being twice as high as dividends on a consistent basis.
  • Second, and actually more important, you need to reassure yourself that the company has enough cash to pay the dividend. This is because clever accounting can make earnings look better than they actually are. Cash is much harder to fudge.

If you look on the factsheet for a company at fidelity.co.uk it is easy to find the most important numbers. Scroll down until you find ‘Company Financials’. Click on this and you will see three sets of numbers, put together by our partners at Morningstar - the Income Statement, Balance Sheet and Cash Flow. It’s the last of these we are interested in.

Look for a figure called ‘Free Cash Flow’ (this is the amount of cash left over after essential payments like capital expenditure have been made). You want to check that this is greater than the figure just above it - ‘Cash Dividends Paid’.

Obviously, there is a lot more to analysing a company’s accounts than this. If it were this simple, we wouldn’t need analysts and accountants. But making a few simple checks like this can save you from expensive mistakes.

And if this all seems like too much work then let a good fund manager do the sums on your behalf. The ability to work through the numbers is, of course, a pre-requisite for a manager to make it onto our Select 50 list of favourite funds.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. The FTSE 100 yields is quoted is not guaranteed and will fluctuate each day in line with the share prices on the stock market. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.