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Are thin dividend covers a concern?

Last week, amidst all the headlines about the FTSE100 and FTSE250 being at or within sight of record levels, against a backdrop of a collapsing pound, there was concern in some areas surrounding the risks to company dividends at a time when the UK economy might be on the cusp of an economic slowdown, if some of the more colourful warnings are to be heeded, as we look towards the end of the year.

Thus far the economic data shows a UK economy responding particularly well despite the fallout from the summer Brexit vote, while the global economy continues to show signs of a tepid recovery.

Dividends are particularly important given that the Bank of England has driven UK gilt yields even lower, which means for pensioners and pension funds dividend income is more important than ever.

As a stock market investor one should always be alert to the prospect of dividend cuts, indeed at the beginning of this year there was a lot of concern about the sustainability of oil company dividends at a time of multiyear low oil prices.

Despite the rebound in oil prices since then, this remains a real concern despite the rebounds seen in both BP and Royal Dutch Shell’s shares price, which means investors need to do their homework, not only on the vulnerable sectors like oil and gas, and banking, but in other sectors too.

A very simple test is a ratio called Dividend Cover which in simple terms shows how feasible it is for the company to pay a dividend. In simple terms profits need to be at least double the amount of the dividend paid out, which would give a dividend cover of 2.

Anything less than 1 suggests that the dividend could be at risk of being cut, as the company is paying out most of its profits in the form of dividends, and leaving no buffer in the event of an economic shock, while a negative number means the company is paying a dividend while making a loss, which isn’t sustainable in the long term, and as such could be susceptible to a cut.

The average dividend yield on FTSE100 companies sits at around 4% which in the current low yield environment is a decent return, which means any company paying anywhere near double that amount needs to ask itself if that is sustainable, especially if its dividend cover is less than 1.

On current share prices there are only 48 stocks in the FTSE100 that currently fit the criteria of a 2% dividend cover, and when you add a 2.5% minimum dividend yield as an additional criteria, that drops to 22, which means that there is a sizeable majority that don’t this criteria.

That doesn’t mean as a shareholder you should fear a dividend cut. A cut from 7% to 3.0%, for example, would still be above the level of inflation as well as bank base rates, however you would need to be prepared for a sizeable drop in the share price that such a cut might bring about.

CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.