Remember, a company can only pay cash to shareholders if it's making money, or if it has enough funds in reserve to keep up the dividend through the lean times. So, investors must subject company balance sheets to a thorough health check. Paying down debt and investing for growth tells us earnings are probably improving and that free cash flow will drive future dividend growth.
Look at the transport sector. A lot of the bus and train operators yield way above average, but chaos surrounding the rail franchise system has called into question whether some of them can keep paying the dividend out of earnings from bus operations alone.
Dividend cover and payout ratio - sustainability
It's essential that any income seeker knows whether a company can actually afford to pay shareholders a dividend, and finding out how sustainable payouts are is extremely straightforward.
Simply dividing the earnings per share (EPS) by the dividend gives what is called dividend cover. The accepted rule is that earning should be about twice the size of the dividend, but a ratio of 1.5 is usually acceptable. However, anything below that suggests the company may struggle to finance returns in the future, and less than 1 means any payout will have to come from retained earnings in previous years. That cannot go on forever.
Of course, dividend cover can also tell us whether a company is not being generous enough. Yes, management will need money to fund their growth aspirations, but cash piles can also be a big red flag and increase the temptation for ambitious chief executives to make value destroying acquisitions.
Analysts, especially those in the US, like to refer to the payout ratio when deciding if there's scope for dividends to grow. It's the same as dividend cover, just expressed as a percentage of earnings rather than a multiple. Currently, the payout ratio for the MSCI World index is just 40 per cent compared with an average of over 44 per cent since 1996.
It's about the same for the UK, but that's well below the 30-year average and much lower than the previous best ratio up in the high 50s. Of course, each sector is different. Utilities have tended to pay around 60 per cent of earnings back to shareholders, whereas miners, whose profits are highly cyclical, prefer to throw their excess cash at acquisitions and new projects. On the whole, many companies are generating higher margins and profit than ever and will find it increasingly difficult to justify keeping payout ratios at historic lows.
