The dividend coverage ratio is one of the most popular ratios for analysing dividend stocks.
This ratio measures how comfortably a company can cover its dividends with its earnings, and is calculated by dividing a company’s earnings per share by its dividends per share. The general rule of thumb is that coverage of two times is healthy, while coverage under 1.5 is more risky.
The dividend coverage ratio is a popular ratio because it’s easy to understand and easy to calculate. However, there is one flaw with the dividend coverage ratio, and that is that earnings, the numerator, can be manipulated.
Companies can use all kinds of accounting tricks to manipulate earnings, and therefore by assessing a company’s dividend against its earnings, perhaps we are not looking at the most important figure for dividends – cash.
The cash dividend payout ratio
With that in mind, another ratio that is worth calculating, in order to assess dividend sustainability, is the cash dividend payout ratio.
This ratio is calculated by the formula below:
Cash Dividend Payout Ratio = Common Stock Dividends / (Cash Flow from Operations – Capital Expenditures – Preferred Dividend Paid)
The cash dividend payout ratio is effective at assessing dividend sustainability for several reasons.
First, a company requires cash to pay a dividend. Dividends are not paid out of earnings, they’re paid out of cash. Second, cash flow from operations is harder to manipulate than earnings, and therefore possibly gives us a more accurate assessment of whether the company can afford to pay its dividend.
The ratio subtracts two items from cash flow from operations that will need to be paid before ordinary dividends. These are capital expenditures – funds needed to invest for the future and keep the business running, and preferred dividends, which generally have to be paid before ordinary dividends are paid. What is left is cash flow that is available for ordinary dividends.
The lower the ratio the better. For example, a company with a cash dividend payout ratio of 30% most likely has a better chance of sustaining its dividend than a company with a cash dividend payout ratio of 120%.
So next time you’re analysing a dividend stock, have a look at the cash dividend payout ratio. You may be surprised by the results.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.