Three ways to ‘stress test’ dividends

Forget double-baggers. Right now, many investors would settle for finding a reasonably safe stock, that offers them a fighting chance of beating inflation. How hard can that be?

Sadly, it's a quest that's fraught with pitfalls. The biggest is that a firm offers you a juicy dividend as a bribe to buy its shares and then slashes it or even goes bust. So how do you find a solid dividend income that is also reliable?

We are fans of generous blue-chip dividend payers without them, it's been hard to make any money from FTSE 100 stocks for a decade, as capital gains have been nigh on non-existent. The discipline of paying regular dividends is also good for management teams that might get distracted into taking unnecessary risks with your cash.

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But many large caps are not very generous the index as a whole yields just under 3.5%. With the retail price index rising at 4.7% a year, that's not enough to stop you losing money in real terms.

As a basic-rate taxpayer, you need at least 5.3% to break even and that currently limits you to fewer than ten FTSE 100 stocks. Set the bar at, say, 6%, and you are down to just four, all of which are financial firms (three insurers and a hedge fund). So where else can you look?

One answer is among smaller-cap firms, where 6%-plus yields are available from a range of sectors. However, with small caps, you could be taking on more risk. How do you separate the short-term dividend bribers from the longer-term steady payers? Once you've identified an attractive yield, here are three ways to test whether it's sustainable.

Does the firm generate consistent free cash flow?

When it comes to dividends, cash is king. Sure, a firm needs to generate a profit too and decide how much of it will be paid out as a dividend (the more that's paid out, the higher the payout ratio), but without consistent cash flow it has little hope of sustaining a generous (6%+ yield) dividend policy.

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There are several cash-flow figures you can look at, including a firm's cash-flow statement. However, the key one is free cash flow. That's cash available from operating activities once you deduct the stuff that has to be paid, such as loan interest, taxes and maintaining the long-term asset base. It's consistency you are looking for. So ideally you want figures from the last three or five years. If they swing wildly, veering into negative territory, be cautious.

Emerging-markets fund manager City of London Investments (LSE: CLIG) cuts the mustard. The yield is 6.8% and, despite difficult conditions in emerging markets (which have dented assets under management by one sixth), the firm increased sales and profits in its latest statement. Free cash flow generation has been consistent for the last five years, helping the directors more than double the dividend since flotation in 2006.

Is the dividend covered?

How many times could the current year dividend have been paid out of profits? The higher the better, as directors could have scope to raise future dividends.

The standard test is to compare the profit after tax figure in the profit and loss account to the ordinary dividend (interim and final) just below it as a multiple. Or you can compare earnings per share (EPS) to the dividend per share (DPS). So if EPS is 45p and DPS 22p, dividend cover is just over two. That's a good level of cover for large caps, although it's often hard to find among small caps. Here around 1.5 is acceptable as a base figure. But don't stop there.

The back-up calculation that's worth doing is the cash flow version. There are several, but my favourite is to compare free cash flow per share to the dividend per share, again with a minimum of 1.5 times. So, for example, car parks operator and property firm Town Centre Securities (LSE: TCSC) may boast a yield of 7.2% covered 2.9 times by profits, but free cash flow cover is just 1.1 times. Construction group Morgan Sindall (LSE:MGNS), however, offers a yield of 6.4%, but it is almost twice covered by profits and more than five times covered by free cash flow.

Are the directors committed to dividend growth?

Income investing is about consistency. It's no good if directors try to impress you with a quick dividend boost if they've no track record in making regular payments and increasing them over time. There are two ways you can get a feel for how reliable a high yielder will be in the future.

First, look at the dividend growth rate over three to five years. You want a sensible, sustained rate of growth. It's no guarantee, but it suggests a degree of commitment to shareholders.

As the Motley Fool's Maynard Paton notes, this is more likely when you have "dividend-devoted directors at the helm". At City of London Investments, Morgan Sindall and Town Centre the top brass own a decent (over 10%) stake and collect a steady income. So although there are no guarantees, they won't change dividend strategy, at least your main interest as an income-seeker is aligned with theirs.

This article was originally published in MoneyWeek magazine issue number 574 on 2 February 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.