In the prior lesson of this dividend investing course, we discussed one way to spot a risky dividend before it's too late using the dividend payout ratio.
It's never a good idea to rely on a single ratio for your analysis. In this post, we'll discuss some other tools you can use to determine if a company's distributions to shareholders are sustainable in the long term.
You will learn how to use the dividend coverage ratio to pick winning dividend stocks and avoid the losers.
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What Is The Dividend Coverage Ratio?
The dividend coverage ratio is a financial indicator that tells you how many times a company's operating cash flow can cover the dividend. If a company generates $50B cash flow from operations and pays $10B in dividends, it has a dividend coverage ratio of 5x.
Just like the dividend payout ratio, the dividend coverage ratio is a powerful instrument in the hands of income investors, as it can help avoid bad investment decisions.
If you find a stock with a 15% dividend yield, you may be tempted to buy it in hopes of enjoying a substantial income stream. But what if the company has a 0.4x dividend coverage ratio? A dividend coverage ratio below 1.0x suggests that the company can't pay its dividend using cash flows earned from business activity -- a situation that is not sustainable in the long run.
To pay the dividend, the company must finance it using alternate means. These alternative means include:
- Using cash earned or raised in prior periods
- Selling plant, property, equipment or other tangible or intangible assets of value owned by the company
- Issuing additional debt or equity
Since a company can't do the activities mentioned above in perpetuity, eventually, the company's board of director would be forced to reduce or suspend the dividend.
How To Calculate The Dividend Coverage Ratio: Formula Explanation
The dividend coverage ratio tells you the number of times a company's operating cash flow can cover its dividend. Here's the dividend coverage ratio formula:
Dividend Coverage Ratio = Cash Flow From Operations / Total Dividends Paid
Some investors prefer to calculate it as the reciprocal of the dividend payout ratio, to check how many times a company can cover the dividend with its earnings. Here's the alternative formula:
Dividend Coverage Ratio = Net Income / Total Dividends Paid
You may be wondering which best dividend coverage ratio formula you should use. At Finbox, we use the cash flow version since cash from operations is harder to manipulate than reported net income. Furthermore, it is essential to check for cash flow profitability to get a more genuine sense of a company's ability to handle the dividend with ease.
The pressure on management to consistently deliver strong earnings is real and well documented as earnings management. Net income may govern stock price reactions, but income investors need to be confident that a company has the cash flow to pay its dividend.
Dividend Coverage Ratio: Example Calculation
To illustrate, we can use the formula above to calculate Microsoft's (NASDAQGS:MSFT) dividend coverage ratio:
Microsoft's Cash Flow From Operations / Microsoft's Total Dividends = Microsoft's Dividend Coverage Ratio
Using the Finbox data explorer, we can find the values of the metrics required to apply the formula:
We can now calculate Microsoft dividend coverage ratio by dividing the cash flow from operations by total dividends:
Microsoft Dividend Coverage Ratio = $58.11/ $14.793 = 3.9x
Microsoft's coverage ratio suggests that the company can pay its dividend 3.9x times with its cash flow from operations. That puts Microsoft around the 50th percentile for dividend-paying stocks in the U.S. Information Technology sector.
Dividend Coverage Ratio: Sector Benchmarks
As of July 4, 2020, the sectors with the highest dividend coverage ratios are industrials, healthcare, and energy. Real estate, consumer staples, and utilities are the sectors with the lowest dividend coverage ratio.
What Is A Good Dividend Coverage ratio?
If you're trying to determine what constitutes a good dividend coverage ratio, there are no hard-and-fast rules. For some investors, a dividend coverage cushion above 1.5x is sufficient, while others consider a coverage ratio higher than 3.0x as healthy.
As you can see from the chart above, dividend payout ratios vary considerably from one sector to another, ranging from 5.65x for industrials to 2.83x for consumer staples.
A healthy dividend coverage ratio is above one (1) and the sector average. When a company pays a high dividend compared to other companies in the sector, there is a high chance that the distribution is not sustainable in the long term as the dividend may need to be cut at the first sign of a recession or financial hardship. A high payout may also indicate that the company is not retaining enough cash to reinvest and compete effectively in the market over the long-run.
A dividend coverage ratio below 1 is a critical leading warning sign across nearly all sectors. One exception is real-estate – a dividend coverage ratio below 2x could be fine for a company structured as a REIT since REITs required by law to distribute 90% of taxable income to retain their tax-efficient structure. Using the Finbox Stock Screener, I exported a listed of dividend coverage ratios for U.S. REITs.
|REIT - Dividend Coverage Ratios|
If a company has a dividend coverage ratio that is well below the sector average, income investors should investigate to ensure that the situation is temporary and that the company has a generally healthy financial position.