Chapter 6: Dividend Checks

Introduction

DIVIDENDS ARE THE sum of money paid regularly by a company to its shareholders out of its profits (or reserves). For income companies, it’s important to check that payment of future dividends is sustainable and therefore likely to continue. It is also important to check that the dividends have scope to grow above the rate of inflation over time.

Progressive dividend history

A rising dividend is a signal that an income company is confident in its prospects. You can check that there has been a gradual increase in the dividend by looking at the history of dividends per share (DPS). Morningstar provides a history of DPS in the financial section of the company profile. If the dividend has been cut in the past five years, the company can be removed from consideration.

The dividend growth rate trend should also be considered. A company that has markedly slowed its dividend growth rate or has held the dividend constant for a few years may be signalling trouble ahead. Of course, every company’s dividend growth rate will eventually slow as they mature, but the decline will likely be gradual and steady. If there is an abrupt slowdown in the dividend growth rate, there may be trouble ahead for the company.

Example

Table 6.1 shows the dividend history for XP Power. Dividends have been gradually rising since 2010. Over the past five years, dividends have grown by 13.7% per annum (= (78 ÷ 41)^(1/5) – 1). However, dividend growth slowed in 2017, albeit growing at a healthy 9.9%.

Table 6.1 Dividend per share – XP Power

(f) indicates broker forecasts, taken at December 2018.

Expected future dividends

Consensus broker forecasts for dividends over the next two years can be found on Stockopedia on the main company profile. Ideally, the consensus dividend forecast for the following year should be higher than the previous year; this indicates that the market doesn’t anticipate that the dividend will be cut. Eliminate income companies from the shortlist where forecast dividends are cut.

Example

Table 6.1 shows that the broker consensus expects dividends to grow by 5.7% (= 82.5 ÷ 78 – 1) in 2018 (slower than in 2017) and by 6.1% (= 87.5 ÷ 82.5 – 1) in 2019. The growth rate is therefore expected to be slower than previous years. However, a growth rate above 5% is still reasonably good.

Dividend cover

Companies that aren’t generating enough profit (or free cash) to cover the dividend are more likely to cut the dividend. Dividend cover is EPS divided by DPS, which indicates how many times the dividend is covered by earnings.

Looking at just one year of data can be misleading as a company could have an unusually good or bad year. One needs to look at the overall trend of historic dividend cover and the projected dividend cover, which is based on broker forecasts of earnings and dividends. If dividend cover is declining, it can be a sign that the dividend payout is becoming riskier and may not be sustained.

Morningstar provides a history of dividend cover in the income statement of the financial section of the company profile. Forecasts for dividend cover over the next two years are stated in the Stockopedia company profile. Ideally the company should have a stable, or gradually increasing, dividend cover that remains above 2. If dividend cover looks like it is trending down and will fall below 1.5, eliminate the company from the shortlist.

Example

XP Power’s dividend cover history is shown in table 6.2. The dividend cover has been gradually trending down since 2010. However, broker consensus expects the dividend cover to improve as well as be above 2 in 2018 and 2019.

Table 6.2 Dividend cover – XP Power

(f) indicates broker forecasts, taken at December 2018.

Dividend outlook

Dividend statements in annual reports, interim statements and news releases can provide an indication of a company’s commitment to maintaining and growing the dividends paid out. You should look for companies that have a positive dividend outlook and a strong commitment to growing the dividend over time.

Read the last few years’ dividend statements in the annual and interim reports (usually available on a company’s website for investors) to get a better understanding of whether a company has been able to deliver on the dividend growth it anticipated so far. You should also look for guidance on what the company is aiming to pay out in dividends over the next few years.

Example

XP Power has pursued a progressive dividend policy over the past ten years, supported by strong cash flow generation. XP Power’s policy expects to continue increasing dividends, while maintaining a dividend cover around 2.

Average future five-year dividend yield

To calculate the average dividend yield over the next five years, a conservative estimate of future dividend growth is needed as well as the latest reported annual dividend and share price.

It is assumed that future dividend growth can be proxied by the minimum growth rate of dividends, earnings and revenue over the past five years. If the earnings or revenue growth rate is below the dividend growth rate, the future dividend growth rate will be restricted.

The next five years of dividends are estimated to be:

D₁ = (1 + g) × D₀

D₂ = (1 + g) × D₁

D₃ = (1 + g) × D₂

D₄ = (1 + g) × D₃

D₅ = (1 + g) × D₄

This is where D₀ is the latest reported annual dividend, g is future dividend growth and D_i is the dividend paid i years into the future.

Therefore, the average dividend paid out over the next five years can be calculated using D_avg = (D₁ + D₂ + D₃ + D₄ + D₅) ÷ 5. The average dividend yield over the next five years is then calculated by dividing this average by the share price, i.e., D_avg ÷ P.

Example

From table 6.2, XP Power’s dividend was 78p in 2017, meaning that dividends grew by 13.7% over the past five years. Previous chapters have shown that average earnings grew by 12.4% and sales grew by 12.2% per annum. The future dividend growth is therefore assumed to be 12.2%.

This means that the annual DPS over the next five years is expected to be 87.5p (= 78p × 1.122), 98.2p (= 87.5p × 1.122), 110.1p (= 98.2p × 1.122), 123.5p (= 110.1p × 1.122) and 138.6p (= 123.5p × 1.122).

The average dividend over the next five years is D_avg = 111.6p 
(= (87.5p + 98.2p + 110.1p + 123.5p + 138.6p) ÷ 5). The average dividend yield over the next five years is therefore 5.2% (= 111.6p ÷ 2130p).

If you want to be more sophisticated, you can determine the average five-year dividend yield using the broker consensus dividend forecasts to augment the calculation. In this case, the broker’s forecasts for year one and two are used for D₁ and D₂, respectively. The remaining three years of future dividends 
(D₃, D₄, and D₅) are calculated as before.

Example

XP Power’s consensus broker forecasts for 2018 and 2019 are 82.5p and 87.5p (from table 6.2). If future dividends then grow by 8.6%, dividends in years three to five will be 98.2p (= 87.5p × 1.122), 110.1p 
(= 98.2p × 1.122) and 123.5p (= 110.1p × 1.122).

The average dividend over the next five years is D_avg = 100.3p (= (82.5p + 87.5p + 98.2p + 110.1p + 123.5p) ÷ 5). The average dividend yield over the next five years is therefore 4.7% (= 100.3p ÷ 2130p).

Income companies are removed from the shortlist if they do not offer an average dividend yield in excess of the market dividend yield plus 1%, with a maximum requirement of 4%. For example, if the FTSE All Share yields 4.3% then the average dividend yield needs to be above 4.0% (which is the minimum of 5.3% and 4%).

Value companies should have an average dividend yield above 3%. This allows value companies to earn a dividend that can keep pace with long-term inflation, while waiting for their true value to be recognised.

Sector comparison of dividend yield

Some sectors tend to have higher yields than others. It is worth comparing a company’s dividend yield to others in its peer group. A company that has a dividend yield significantly higher than its sector average may be more inclined to cut the dividend if it runs into trouble, as it can afford to lower the dividend and remain attractive to investors. Remove companies from the shortlist that have dividend yields that are more than double the sector average.

Example

Table 6.3 shows the dividend yield of XP Power based on a share price of 2130p. The current dividend yield is 3.7% (= 78 ÷ 2130); broker consensus expects this to rise to 3.9% in 2018 and 4.1% in 2019, as the dividend grows.

The current dividend yield of 3.7% is above the sector average of 2.3%. At only 1.6 (= 3.7 ÷ 2.3) times the sector dividend yield, it is not so far above the sector average to be of concern.

Table 6.3 Dividend yield – XP Power

(f) indicates broker forecasts, taken at December 2018.

Dividend checks for growth companies

It is desirable for growth companies to pay a dividend because it helps reinforce financial discipline – the company must have the cash to pay the dividend. Your preference should be to invest in those with a dividend yield above 1%. However, a low dividend yield is desirable for growth companies as management should be aiming to reinvest most of its retained earnings into the business to maximise its earnings growth.

Summary

Key dividend checks are summarised as follows:

Dividends checks for income and value companies

· The dividend is progressively increasing over time.

· Dividend cover is above 1.5.

· Broker consensus expects dividends to rise over the next two years.

· The dividend outlook in the annual statement has a commitment to growing the dividend over time.

· The average dividend yield over the next five years should be 1% above the FTSE All Share dividend yield up to a maximum of 4% for income shares and above 3% for value companies.

· Dividend yield is less than two times the sector dividend yield.

Dividend check for growth companies

· For growth companies, the dividend yield should be above 1%.