How safe are your dividends?

Julie Brownlee, Fsp Invest, 06 Jul. 2015

Tags: dividends, dividend, dividend cover, dividend pay-out ratio, dividend safety,

Dividends make up a substantial amount of the returns from the stock market. And if you invest in dividend paying stocks, it’s important to check their future prospects.

So how can you weigh up whether a company is going to continue to pay dividends? And can you find out if a company is likely to increase its dividends?

Read on to find out…

How to check out future dividends

If you want confirmation that a company is going to continue to pay out a dividend or increase its current dividend, you can look at its dividend cover for hints.

To work out a company’s dividend cover, you need to know its earnings per share (EPS) and its dividend payment per share (DPS).

Then use the following calculation to check how safe your dividends are…

Dividend cover = EPS/DPS

This calculation tells you how many times a company’s profits cover its current dividend.

For example, if Company ABC has EPS of 300c and pays out a dividend of 100c, its dividend cover is 3 (300c/100c).

With a dividend cover of 3, a company would be able to withstand a large drop in profits before having to cut its dividend.

Using dividend cover to work out the dividend pay-out ratio

Once you know what the dividend cover is, you can work out the dividend pay-out ratio…

Dividend pay-out ratio = 1/dividend cover

This tells you the proportion of a company’s profits it pays out in dividends.

For Company ABC, the dividend pay-out ratio is 33% (1/3).

If a company has a low dividend pay-out ratio, it suggests its dividend is safer. It can also indicate that a company could increase its dividend in the future.

To give you further confirmation of what you find out from performing these calculations, you can also use a company’s free cash flow per share in place of EPS.

If a company’s dividend cover and pay-out ratio remain low using free cash flow, it shows a company has the cash to pay dividends.

So there you have it. How to check if your dividends are safe.

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