How safe are your dividends?

Dividend investing buying shares with high dividend yields can be a very good strategy. It has become a popular way to invest in today's world of rock-bottom interest rates.

Fed up with receiving next to nothing on savings accounts, many people have decided to put some of their money to work in the stock market. Here the income available, or dividend yield, may not only be much higher than the interest from savings accounts but can also grow for many years to come if you pick the right company.

The great thing about dividends is that they give you a return from your investment that is not subject to the ups and downs of the market once paid, it cannot be taken away. This is good if you need the income to live on, but if you are prepared to use your dividend payment to buy more shares every year a process known as dividend compounding then you can turbo charge your savings and build up a hefty nest egg over the long haul.

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This is all fine in theory, but what happens if the company's dividend payment is reduced or not paid at all? This happens all the time, but more so when business is bad or the economy slumps. How can you avoid these types of companies?

Check dividend cover

There's no shortage of dividend safety checks. The one most cited is the dividend cover ratio. It looks at how many times the profit for shareholders (earnings per share) covers the dividend per share. Depending on the type of business concerned, a dividend cover of two or more is taken by many to show a relatively safe dividend.

So a company with earnings per share (EPS) of 100p may be viewed as being easily able to pay a dividend per share of 50p. A company with very stable profits, such as a water company, may feel able to pay a dividend as high as 75p.

The trouble is there's no shortage of companies that have started the year with comfortable levels of dividend cover, only to slash the payout later in the year when their fortunes turned down. It's difficult to predict these events, but you can watch out for signs that increase the risk of this happening.

The first thing you should do is look at a company's dividend history. If a dividend has been cut in the past, then there's a good possibility that it can be cut again.

Look for low-interest cover

Interest cover (defined as operating profit divided by interest payable) can be used to highlight a risky dividend. Interest payments on debt are not optional and have to be paid before shareholders get anything. If a company's trading profits are not sufficiently comfortable to pay its interest bill, then a downturn in business can see a dividend cut to free up cash to pay its lenders.

Be careful of high fixed-costs

Some businesses, such as manufacturers, have high fixed-costs costs that are the same regardless of the level of sales. These companies are known as being operationally geared, in that changes in profits are sensitive to changes in sales. They can be good to own when times are good, but terrible during bad days. Companies with high fixed-costs should have stable income streams (such as utilities) or low levels of debt. Dividends from companies that don't have these can be hard to rely on.

Avoid declining returns

Companies can buy profits. They do this by buying other companies or investing in new assets, such as factories or shops. This can allow profits and dividends to keep on going up for a while and give the impression that everything is alright when often it is not.

One way to spot this is to look at a company's return on capital employed (ROCE). If profits are going up by less than the amount of money invested in the business, then returns to investors will fall. This can be a red flag warning of trouble ahead. What will happen when the spending stops?

It's also vital to look at the company's ability to generate surplus (or free) cash flow. This is the cash that is left over after all non- discretionary bills such as interest, tax and an amount of money to keep the company's assets in working order have been paid. You can work this out for yourself from a firm's cash-flow statement. If free cash flow per share is consistently lower than the dividend per share, then the payout to shareholders may not be sustainable.

Beware management that promises riches

It's becoming more common for companies to target dividend payouts and their growth for the next five years or so. Regulated utilities often do this, while housebuilder Persimmon, for example, has also set out a multi-year target.

This can be a good thing, as investors like certainty. But it may mean that companies pay out too much money only to have to cut back at a later date if profits aren't high enough.