Are your dividends safe?

Dividends are a key component of a stock's return. If you had put £100 into the FTSE ten years ago, you would have made less than £14 solely from the change in prices. However, if you had reinvested the dividends, you would have seen your original investment grow to more than £170. What's more, successive studies have shown that high-yielding stocks tend to be better investments. Indices composed of these stocks have usually (but not always) beaten the main indices. For example, the MSCI Europe High Dividend Yield index has outperformed the MSCI Europe index since 1999.

However, just because high-yielding stocks perform better on average doesn't mean that they are always a good investment. The mining and energy sectors have become a favourite destination for investors looking for income stocks over the past decade. But lately their share prices have crashed, as the Chinese slowdown and the plunging price of crude and base metals have slashed profits. Worse, the sudden reduction in income has also meant that many are cutting their dividends as they scramble to cover costs. Last month, Glencore scrapped its dividend completely as part of a plan to reduce the level of debt on its books.

So how can you avoid being lured into high-yielding stocks that fail to deliver the promised dividend? One method that some investors use is to focus on the dividend cover the ratio of profits to dividends. The higher the dividend cover, the more secure the dividend should be.

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A firm with a dividend cover of less than one (meaning that its profits are lower than its dividends) may temporarily be able to pay out more money than it makes, if profits are unusually low or it's returning the proceeds of a one-off event such as an asset sale to shareholders. But a firm won't be able to pay dividends greater than profits for very long without running up unsustainable debt.

That said, as we've noted before on this page, there's not a great deal of evidence that low dividend cover is the best way of predicting whether a given firm's dividend is under immediate threat other measures, such as the strength of the balance sheet, may be more useful (see box below).

What's more, high dividend cover isn't necessarily a good thing either. Many firms, especially in sectors such as technology, choose to reinvest most or all of their profits. Done properly, this reinvestment can lead to higher future profits, increased dividends in the long term and more money for patient shareholders. But very low payouts may also mean that the industry has low returns on capital or that management is wasting money on vanity projects or wasteful acquisitions.

So if your focus is on firms that can grow their dividends over the long term, you need to look at the return they are making on the money they retain, not just how much they are paying out. Measures such as return on invested capital (ROIC) give an indication as to whether managers are reinvesting shareholders' money in a productive manner. If ROIC is high and stable, then growth should strengthen its ability to pay dividends, and therefore increase its overall value.

However, if returns are low, this suggests that management should be returning money to shareholders directly through higher dividends now, allowing shareholders to reinvest it more profitably elsewhere.

A better way to weigh a balance sheet

writes Cris Sholto Heaton

We've previously written about this in MoneyWeek, most recently in May. Back then, it was flagging up Sainsbury's and Glencore as the high-yield UK large-caps that were most likely to cut their dividends. Sainsbury's did so within days and Glencore followed last month. The model also identified fellow miner Anglo American as high risk: this firm has yet to cut, but is widely expected to do so.