Measuring Dividend Quality

With fixed income yields at record lows across the developed world, income-seeking investors have had a tough decade. Ever since the financial crisis of 2008, the yield on government 10 year treasury bonds has tumbled from around 5% to 1.68% (investing.com). The hunt for income over the past decade has led investors to either buy-to-let properties or dividend stocks.

A number of FTSE 100 companies pay dividends many times greater than the income from fixed income securities. Most of these are household names. Vodafone, for example, pays out nearly 9% of its current stock price in dividends. Similarly, National Grid, Marks & Spencers, and the Royal Mail PLC offer dividend yields of 7.58%, 8.18%, and 9.51% respectively. The overall FTSE 100 pays just over 4% in dividends (David Brenchley, Morningstar, 23 April, 2018).

Such handsome dividends coupled with the opportunity for price appreciation make dividend stocks an ideal asset class for income seekers. However, investors need to take a closer look to ensure the dividends are sustainable. A sudden plunge in the stock price or an unexpected cut in the annual dividend payout could negatively impact the total return from these stocks.  

It is essential to establish a connection between a company’s dividends and its underlying economics. Companies need to have adequate annual earnings to cover their expected dividends. A dividend coverage ratio (net income divided by dividend) of greater than 1 is absolutely essential. Firms also need to have adequate cash, low debt, and healthy growth prospects to sustain the dividend long term.

Another important factor dividend investors must consider is the management’s philosophy. A number of cash-rich and stable businesses do not offer a dividend because the management believes it can generate a higher return for shareholders by reinvesting the free cash flow back into the enterprise. The most prominent example of this is Warren Buffett’s Berkshire Hathaway, which has never paid a dividend in its 54-year history (Aristofanis Papadatos, Seeking Alpha, Feb. 28, 2018). That’s despite the fact that the company’s cash hoard recently reached $116 billion. With this in mind, income-oriented investors need to pay close attention to a change in management or its dividend policy.

A well-diversified, high-yield dividend portfolio can help investors who rely on their investments for income. However, the cash flow from dividends is often unpredictable over a longer time horizon. Investors need to periodically check the financial health of the business to ensure their quarterly payments are sustainable.

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.

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