If you're buying stocks for their dividends, it makes sense to only purchase those companies capable of making their biannual or quarterly payouts. How do you ascertain this? By looking at the dividend cover.
Before your eyes glaze over, let me quickly say that this isn't something that's difficult to understand or calculate. Put simply, this number tells you how well a dividend is payable from that year's profits. To find this out, just divide a company's earnings per share by the dividend per share.
If Company X achieved full-year earnings per share of 30p and paid a total dividend of 15p per share, the dividend cover would be two (30p/15p). This means that half of a company's profits are paid as dividends with the remaining half being reinvested back into the business. While some investors would argue that it's far better for all profits to be reinvested, this degree of cover is usually regarded as indicative of sound financial discipline.
If Company X's dividend cover were to dip below one, however, it would mean that at least some of the payout is being paid for from reserves. If cover continues to decline each year then the likelihood of the dividend being reduced or even scrapped increases.
Run for cover
The importance of a company being able to cover its dividends is the reason why I currently refuse to have anything to do with communications giant Vodafone(LSE: VOD), despite the undeniably tempting 6.2% yield on offer for 2017.
Over recent years, Vodafone's dividend cover has been pretty awful. For the current year, it stands at just 0.43. At 0.52, the forecast cover for 2018 isn't much better. Can the situation improve? Given the expected reduction in capital expenditure, that's certainly possible. The question is whether it's worth the risk in the meantime. With shares trading on 37 times earnings and the latter not expected to recover until 2018, I really don't think it is.
Of course, Vodafone isn't the only offender when it comes to cover. £3.8bn cap industry peer, Inmarsat(LSE: ISAT) also occupies a space on the dividend naughty step. Indeed, its 5.4% yield for 2017 looks decidedly less compelling when it's discovered that the cover on this will be even lower, at 0.88, than it was in 2016 (at 0.99). Such low cover makes the predicted 5% hike to its dividend in 2017 look even more questionable.
Back in March, Inmarsat reported a 13.7% decline in profits to just over $243m. While better than some analysts were expecting, this is hardly the sort of number to inspire confidence. A further 7% reduction in earnings per share expected this year leaves the shares trading at over 21 times forward earnings. All this before the company's net debt levels of $1,895m have even been considered. No thanks.
With the odd exception, I'm usually averse to saying that a company is completely uninvestable, particularly one that occupies a position within or just outside the top tier of the market. Indeed, whenever the majority of market participants start mumbling these words, the investment case for any company certainly warrants closer inspection.
Nevertheless, for those dependent on income from their portfolios, I can't help thinking that there are far safer stocks -- trading on more desirable valuations -- to be found elsewhere.
Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.