There’s a lot more to dividend investing than just buying a stock for its high yield. Investors should always do their research to make sure a company’s dividend payout is sustainable and ideally, offers growth. With that in mind, here’s a look at a few key dividend investing ratios that every dividend should use.
This is one of the key ratios that dividend investors use to assess a company’s dividend sustainability.
Dividend coverage is the ratio of a company’s earnings to its dividend paid and measures how comfortably a company can cover its dividend payout with earnings. The ratio is calculated by dividing a company’s earnings per share (EPS) by its dividends per share (DPS). For example, if a company generates earnings per share of 5p and pays out a dividend per share of 3p, then its dividend coverage ratio is 1.67.
So what ratio should investors look for? Ideally, to ensure dividend sustainability, investors should look for a dividend coverage ratio of around 2.0. A ratio of 2.0 or higher is considered healthy, and indicates that the company can comfortably pay its dividend, while a ratio of under 1.5 is less ideal, and suggests that if profitability was to fall, the dividend payout could be at risk.
A ratio under 1.0 is a warning sign that the company’s dividend payout is unsustainable unless earnings pick up.
This is essentially the reverse of the dividend coverage ratio and is calculated by dividing a company’s dividends per share (DPS) by its earnings per share (EPS). This ratio indicates the proportion of a company’s earnings that is being paid out in the form of cash dividends. A good dividend payout ratio is ideally under 50%. Obviously, a ratio of over 100% indicates that the dividend payout is unlikely to be sustainable unless earnings improve.
Free cash flow to dividends
Because dividends are paid in cash, it’s important to not only look at a company’s earnings, but also its cash flow. To do this, we can look at the ratio of free cash flow to dividends.
Free cash flow per share is calculated by subtracting capital expenses from operating cash flow, and then dividing by the number of shares in issue. Divide this by dividends per share (DPS) to get a feel for the proportion of free cash flow that goes towards the dividend payout. Ideally we want to see a ratio of greater than 1.5.
Debt to equity
Investors should also take note of a company’s financial strength. Specifically, it’s important to examine how much the debt exists on the balance sheet.
As a dividend investor, ideally you want a company that is able to make money without heavy financing needs, because high levels of debt can make a company more vulnerable in the event of a downturn. If profitability slows down, heavy borrowers face the issue of not being able to meet their interest payments and this can mean less cash for dividend payments.
A good dividend stock should ideally have a debt to equity ratio of less than 50%.
It’s also worth checking the interest coverage ratio, which shows how comfortably a company can cover its interest payments. This ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense. Look for coverage of at least 3 times to indicate financial strength.
Dividend growth rate
Lastly, while not a ratio as such, it’s important to examine a company’s dividend growth rate. Has the dividend payout remained static in recent years or is it growing at a healthy rate? The higher the growth the better.
By examining these ratios, the investor should get a good insight into the sustainability of a company’s dividend. And this should help reduce the chances of experiencing a dividend cut.
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.