How safe is your dividend?

Dividends matter. Over the past ten years the share price of utility group United Utilities has been nigh-on flat. Yet with dividends, an investor would have enjoyed around a 90% return. But how can you tell whether the dividend payout is safe and won't be slashed to conserve cash? Many investors focus on a firm's profits. But a much better approach, says Socit Gnrale (SocGen), is to look at balance-sheet strength.

What are balance sheets for?

A balance sheet is a snapshot of financial strength drawn up at the end of a financial year. It sums up what a business owns (assets), what it owes (liabilities) and how the net position (net assets) has been funded (shareholders' funds). The whole thing is checked and signed off by a firm of auditors.

Balance sheets are not perfect. They're out of date the moment you receive them. And they're compiled using odd accounting rules. So, for example, employees (a firm's 'greatest asset', according to many publicity flyers) don't appear anywhere in most cases. Yet when it comes to predicting whether a firm is likely to maintain dividends, they are key.

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Testing dividends

There are many possible ways to test for dividend safety. Dividend cover looks at the number of times profits after tax covers the ordinary dividend the more, the better. And free cash-flow cover looks at the number of times the cash available to the directors for discretionary payments (such as dividends) covers the annual dividend in cash terms. The trouble is both are relatively short-term measures. Cash flows can be highly volatile, so one year's cover may be a poor predictor of future years. Indeed, according to SocGen, 50% of the stocks they surveyed that paid no dividend appeared in the top 40% of stocks when ranked by free cash-flow cover. Luckily, there's an alternative.

One reason why balance-sheet strength is key to dividends is that balance sheets are harder to manipulate than profits or cash flow. Net assets, and the shareholder funds that have paid for them, are accumulated over many years, applying (hopefully) consistent accounting principles. So one year's poor performance shouldn't unduly affect a firm with a solid balance sheet. SocGen's research on dividends bears this out. For Britain, they found that in 2009, 82% of stocks that ditched their dividend were in the bottom 40% of stocks when ranked by balance-sheet strength. This compared to just 4% in the top 40%.

What is balance-sheet strength?

There are several ways to test for balance-sheet strength, but for dividends, SocGen prefers two. The first, the Piotroski F-score, we look at in the box below. The second is an adaptation of Robert Merton's 'distance to default' model. This uses the idea that a firm will default once the market value of its assets falls a certain way below the book value of its liabilities. The further the value of a firm's assets fall, the less likely it is to meet its obligations, and the closer it moves to default. The actual calculation is complex as it uses option-pricing principles. Fortunately, SocGen has bashed the numbers to arrive at some promising tips.

Who makes the grade?

SocGen has combed the market for firms that hit three criteria: first, a Piotroski score of seven or more; second, a balance sheet that ranks in the top 40% on the distance-to-default measure; and third, a dividend yield (the annual dividend as a percentage of the current share price) of at least 4%. Three firms that pass are drug group AstraZeneca (LSE: AZN) on a 4.9% yield; US telecoms firms Verizon Communications (NYSE: VZ), on 6.5%; and utility Hong Kong Electric (HK: 0006) on 4.6%.

At a glance: the Piotroski F-score

Designed by Joseph Piotroski, professor of accounting at University of Chicago, the F-score uses nine criteria to test for balance-sheet strength. The system is simple. A firm scores one point for each test it passes and zero otherwise, based on the most recent set of annual accounts available:

1. Net income was positive.

2. Cash flow was positive.

3. Return on assets is growing (the firm is becoming more profitable).

4. Operating cash flow exceeded net income (profits are converting to cash).

5. Debt is falling.

6. The ratio of short-term assets to liabilities is rising (the company's ability to repay debt is improving).

7. Shares outstanding are the same as last year (the company hasn't issued more shares to raise money).

8. Gross profit margins are rising.

9. Sales rising faster than total assets.

Remember, the F-score is based on the latest set of accounts, so it's only as good as those (already dated) numbers.