Weighing up dividends with dividend cover
You have to tread cautiously when investing in shares for their dividends. Just because a share is paying out a good dividend now doesn’t mean it’s going to continue.
With many companies, particularly commodity producers at the moment, times change and this means cutting dividends to cover costs.
You can check what could lie in store for a company’s dividend using the dividend cover. Dividend cover is a ratio of a company’s profits to its dividends.
The higher the figure, the more secure a dividend should be, Matthew Partridge in Money Week explains. If a company has a ratio of over one, its profits are higher than dividends and it can afford to pay them.
If a company has a ratio of less than one, it may struggle to pay its dividend as its profits are lower than its dividends. If a company in this situation tries to pay its dividends, it may have to borrow money to do it.
But dividend cover can sometimes prove difficult to read. For instance, a company may reinvest a chunk of its profits and only pay out a small amount as dividends. But this reinvestment in the business has the chance to significantly boost future profits.
Looking for long-term dividends
If you’re focusing on dividends for the long-term, you need to look at how hard a company is making the money it keeps work.
You could look at return on invested capital (ROIC). This can show you whether management is reinvesting shareholders’ money productively.
Ideally you want to see a high and stable ROIC. This indicates that growth will add to the company’s ability to pay dividends and boost the overall value of the company.
But if a company has a low ROIC, it should be funnelling money back to shareholders through higher dividends. Shareholders can then put this money to better work elsewhere.
So there you have it. How to find the best dividends.
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