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A different way to weigh up dividends, with surprisingly accurate results

by , 17 November 2015

When you're an income investor, you want to know that your dividends are safe. But it can be difficult to work this out.

Some of the more common approaches to check dividends include calculating dividend cover. But is there another way to check?

Read on to find out…

Using distance-to-default to check dividends

The distance-to-default metric (which is also known as the Merton model), assesses how strong a company’s balance sheet is. You can then use this to assess how safe dividends are.
What this model does is assume that all shareholders have an option on all the assets of the company after creditors are paid off, Cris Sholto Heaton in Money Week explains.
The better the state of a company’s finances, the more each option is worth.
Analysts at Societe Generale think this distance-to-default metric is a good predictor of whether a company is going to cut its dividend compared to using dividend cover. 
By applying this model, it flagged up Sainsbury’s and Glencore at risk of cutting their dividends. Within days of this calculation, Sainsbury’s did indeed cut its dividend. And Glencore did so last month.
The metric also highlighted Anglo American as a company at high risk of cutting its dividend. It hasn’t done so yet, but many analysts think it’s just a matter of time.

Which companies have solid dividends?

Looking at international stocks, the distance-to-default model highlighted the following companies as having the safest dividends:
  • Telstra (telecoms);
  • Wesfarmers (retail);
  • Philip Morris (tobacco);
  • Singapore Telecom (telecoms); and
  • Verizon (telecoms).
They all have dividend yields of over 5%. 
British American Tobacco also fared well using this metric. It is currently sitting on a dividend yield of 3.42%.
So there you have it. A different way to weigh up dividends, with surprisingly accurate results.
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A different way to weigh up dividends, with surprisingly accurate results
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