How to tell if a dividend cut is on the horizon

Dividends are the bread and butter of any portfolio. Most investors will own some dividend stocks, and some will have built their entire investment strategy around dividends.

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But finding those companies with the largest, most sustainable dividend payouts is a tough task. Just going out into the market and buying the shares with the highest dividend yield isn't enough. More often than not the dividend yield is high because investors believe the payout is unsustainable.

If the company does go on to cut the dividend, the resulting markdown in the value of the shares can be substantial and will likely wipe out any gains from dividend income.

A cut ahead?

A higher than average dividend yield is the first indication that a dividend cut could be on the horizon.

Markets are by no means efficient, but they have been extremely accurate at predicting dividend cuts in the past. Indeed, according to data compiled by Mellon Capital, which studied dividend data between 1996 and 2015, a company becomes less likely to pay its predicted dividend if the yield edges over 5%.

According to the figures, on average, companies that offered at least a 10% dividend yield, only paid investors around 3%. Investors expecting a yield of 9% only received an average of 4% and a predicted yield of 6% to 7% only produced an actual return of 5%. Companies with a forecast yield of 4% to 5% generally ended up paying around 4%, at the bottom end of expectations.

Other signs

A high yield is the market's way of telling you a dividend isn't sustainable and there are other pointers to look out for that indicate the same thing.

For example, if a company's dividend payout per share is rising faster than earnings per share, this is a red flag. If a company is paying more and more out to shareholders, but earnings aren't growing at a similar rate, pretty soon management will find itself with no financial headroom. There will be no cash left to invest in growth and then the business becomes somewhat of an annuity, selling off assets and slowly shrinking just to fund the payout. In this scenario, it will only be a matter of time before the payout is cut in an attempt to reignite growth.

Lastly, a lack of cash is a great indicator that a cut is on the horizon. A lack of cash in any business is disastrous. The firm will have to borrow to fund all of its spending needs, which can't go on forever. A lack of free cash flow, a balance sheet that has no cash on hand for short-term needs or a balance sheet stuffed with debt are all signs of a business that's struggling to bring in the cash, and the dividend is under threat.

All in all, picking the best dividends is hard but hopefully, the tips above will help point you in the right direction.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.