Investing Basics: What is a Dividend Yield?

Payouts made by companies to their shareholders are called dividends, and they have been in the news often since the start of the pandemic; faced with great uncertainty many big companies cut or cancelled their dividends in order to shore up their balance sheets as the economic impact of coronavirus took its toll – writes Christian Leeming

 
This dealt a blow to those that rely on dividends on their investments as a source of income; happily dividends returned as markets rebounded and confidence returned.

One of the simplest ways for companies to communicate financial well-being and shareholder value is via cash distributions that send a clear, powerful message about future prospects and performance. A company’s willingness and ability to pay steady dividends over time – and its power to increase them – provide good clues about its fundamentals.

Typically, mature, profitable companies pay dividends, although companies that do not are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, it often keeps the profits and reinvests them into the business – the reason few ‘growth’ companies pay dividends.

One way to identify a company at risk of cutting its dividend is to look at the dividend yield; this is simply the company’s total annual dividend per share expressed as a percentage of its current share price.

For example, if a company paid a total annual dividend of 5p a share this year, and its share price is 100p, the dividend yield would be 5%.

Dividend yield can be based on what a company has paid out during the previous 12 months to calculate the ‘trailing’ or ‘historical’ dividend yield; a risk is that past dividends may not be sustainable.

Alternatively the ‘forecast’ or ‘forward’ dividend yield can be calculated by looking at what the company is expected to pay over the coming 12 months; the risk here is that forecasts can be unreliable.

Companies are under no obligation to pay a dividend, although management teams are often reluctant to cut, as they realise that such moves are rarely welcomed by shareholders.

However, the board might decide not to pay money to shareholders if it believes that it can put that money to better use, or that the dividend is insufficiently well-covered by profits.

How can the dividend yield help you to spot companies in danger of cutting?

A firm with a very high yield compared to other companies in the market or in its sector, may look cheap, and a tempting buy; however, a high yield may indicate that investors expect the dividend to be cut – the yield is high because no one believes it will actually be paid.

If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (a) the share price is high because the market reckons the company has impressive prospects and isn’t overly worried about its dividend payments, or (b) the company is in trouble and cannot afford to pay reasonable dividends.

However, a company with a high dividend yield might also be signalling that it is sick and has a depressed share price.

Dividend yield is of little importance when evaluating growth companies because retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains

There are several other ways to sense-check dividend sustainability.
 

Dividend Coverage Ratio

 
When evaluating a company, consider whether the company can afford to pay the dividend; the ratio between its earnings and the dividend paid to shareholders—known as dividend coverage—is useful for measuring whether earnings are sufficient to cover dividend obligations.

The ratio is calculated as earnings per share divided by the dividend per share; when coverage is thin there is every chance of a dividend cut and the knock on effect to valuation.

A coverage ratio of 2 or 3 should provide comfort, but the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, whereafter prospects start to look risky. A ratio below 1 means the company is using its retained earnings from last year to pay this year’s dividend.

If the payout gets very high, above 5, investors should ask whether management is paying enough cash to shareholders or withholding earnings; managers that raise dividends are telling investors that business will be stable over the coming 12 months or more.
 

Dividend Cuts

 
If a company with a history of rising dividend payments suddenly cuts its payments, investors should be concerned that there is trouble ahead.

Whilst a history of steady or increasing dividends is reassuring, investors need to be wary of companies that rely on borrowings to finance those payments.

An example is the utility industry, which attracted investors with sizeable dividends and reliable earnings, but took on greater debt levels as they tried to maintain dividends, whilst diverting cash into expansion opportunities.

Investors should be wary of companies with debt-to-equity ratios greater than 60%, which can pressure its share price and in turn hamper a company’s ability to pay its dividend.