3 warning signs that your juicy dividend is about to be cut

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These are massive days for dividend investors, with the FTSE 100on course to yield 4.9% this year. That’s incredible given that the base rate stands at just 0.75% and UK 10-year gilts yield just 1.26%.

Maybe too incredible. Standard Life Aberdeen and Vodafone now yield more than 9%, while Centrica, SSE and British American Tobacco top 8%. Once yields hit these dizzying levels, alarm bells should ring as they may be cut. Here are three ways of measuring the danger.

1. It’s just too high

Companies pay dividends out of earnings and have to generate enough cash to fund them. In rare cases they may even borrow money to fund shareholder payouts, but that isn’t sustainable.

The first number to look for is dividend cover, which divides a company’s earnings per share (EPS) by its dividend per share. In the year to 31 March 2019, Vodafone is forecast to generate EPS of 8.64p and pay a dividend of 13.42. This gives a figure of just 0.64, which means the dividend is not covered from earnings.

In a happy world, a company will be able to cover its dividend twice over, giving a figure of 2. Vodafone has a shortfall here, and its dividend looks shaky unless earnings pick up rapidly.

By contrast, British American Tobacco is forecast to generate EPS of 316.68p in 2019, and pay a dividend of 210.34p. This gives cover of 1.5. Its dividend looks more sustainable.

2. Too much debt

Investors are crazy for income these days, and companies want to oblige. However, some are taking too many risks as a result. Last year, Link Asset Services reported that corporate debt has rocketed 69% to £390.7bn since 2011/12. Some £122.6bn was added in the last three years as companies served up £263bn in dividends despite a squeeze on profits, dragging cover to new lows.

You can check whether a company is over-stretching itself by examining its free cash flow, which shows how much it has left over after expenses. A positive number means they can pay dividends without loading up on debt. Just remember that debt is not always a bad thing, it can be positive if invested wisely back into the business.

3. Return on capital employed (ROCE)

I like this measure, which shows a company’s profitability and how efficiently it employs its capital. The higher the ROCE, the better. Some investors will not touch a company with a figure below 15%. British American Tobacco is relatively healthy at 23.8%. However, Vodafone is just 6.1%, which effectively means it earns just £6.10 for each £100 invested. SSE is 9.2%. Standard Life Aberdeen is borderline respectable at 14%.

What you really need to look at is the trend, though. In 2017, Centrica’s ROCE was 5.77%, down sharply from 27.04% the year before. In 2015 the figure was -12.02% and -15.37% in 2014. These negative figures reflect its patchy earnings performance over the period. Cover of just 1 is another worry. No wonder people are worrying about a Centrica dividend collapse.

No measure should be taken in isolation. You also have to consider other factors, such as future earnings growth, and management tenacity in clinging to its dividends. Don’t be dazzled by those sky-high yields, always take a closer look.

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harveyj has no position in any of the shares mentioned. The Motley Fool UK has recommended Standard Life Aberdeen. 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.

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