Some dividends have staying power. Companies delivering enduring dividends tend to back such often-rising payouts with robust business and financial achievement.
Fragile dividends, meanwhile, arise because of weaker operational and financial characteristics. Those are the dividends to avoid. However, fragile dividends often seem tempting, because of high yields.
How to tell the difference
Under the spotlight today, two FTSE 100 firms: Lloyds Banking Group (LSE: LLOY) and mining company Rio Tinto (LSE: RIO) .
These firms operate in different sectors, but they both have a high dividend yield. At the recent share price of 65p, Lloyds’ forward yield for 2016 is around 5.7%. At 1717p, Rio Tinto’s is just under 9%.
Let’s run some tests to gauge business and financial quality, and score performance in each test out of a maximum five.
1. Dividend record
Both firms have paid at least some dividends:
| Ordinary dividend | 2011 | 2012 | 2013 | 2014 | 2015 |
|---|---|---|---|---|---|
| Lloyds Banking Group (pence) | 0 | 0 | 0 | 0.75 | 2.39(e) |
| Rio Tinto (cents) | 145 | 167 | 192 | 215 | 226(e) |
(e) = estimated
Lloyds didn’t pay a dividend for several years, but payments are back on stream now. Meanwhile, I estimate Rio Tinto’s dividend will have advanced around 56% over the four-year period shown.
For their dividend records, I’m scoring Lloyds 1/5 and Rio Tinto 5/5.
2. Dividend cover
Lloyds expects its 2016 adjusted earnings to cover its dividend around two times. Rio Tinto expects earnings to cover the payout just under once.
My ‘ideal’ dividend payer would cover its cash distribution with earnings at least twice.
However, cash pays dividends, so it’s worth digging deeper into how well, or poorly, both companies cover their dividend payouts with free cash flow.
On dividend cover from earnings, though, I’m awarding Lloyds 4/5 and Rio Tinto 1/5.
3. Cash flow
Dividend cover from earnings means little if cash flow doesn’t support profits. Here are the two firms’ recent records on operational cash flow compared to profits:
| 2010 | 2011 | 2012 | 2013 | 2014 | |
| Lloyds Banking Group | |||||
| Operating profit (£m) | 369 | (3,542) | (606) | 415 | 1,762 |
| Net cash from operations (£m) | (2,037) | 19,893 | 3049 | (15,531) | 10,353 |
| Rio Tinto | |||||
| Operating profit ($m) | 19,608 | 13,940 | (1,925) | 7,430 | 11,346 |
| Net cash from operations ($m) | 18,277 | 20,030 | 9,430 | 15,078 | 14,286 |
Volatile cash flow such as Lloyds’ seems common with banking firms. Their arcane accounting practices can make the measure less useful for investors than it might be for companies in other sectors. However, periods of negative cash flow from operations are always undesirable in my book, whatever the company.
When cash flow persistently fails to support profits, companies must make up the shortfall from other financial activities, such as investing or fund raising. Such reliance on activities other than straight-forward banking is a big part of what makes banks such as Lloyds so cyclical and prone to harsh volatility that often exaggerates macro-economic wobbles and financial market undulations.
Meanwhile, Rio Tinto displays robust positive cash flow that supports its profits.
I’m playing it safe and scoring Lloyds just 1/5 for its record on cash flow from operations. Rio Tinto gets 5/5.
4. Debt
Interest payments on borrowed money compete with dividend payments for incoming cash flow. That’s one reason I think big debts are undesirable in dividend-led investments.
Most banks carry big external debts and Lloyds’ borrowings run around 15 times the level of its 2014 operating profit, although earnings rebounded during 2015. However, bank debts come in many forms, so that’s not Lloyds’ only exposure to other people’s money. Meanwhile, Rio Tinto’s borrowings sit at around seven times its current operating profit.
Arguably, banking businesses require, and can justify, high debt-loads. However, I reckon they would make more secure investments with lower levels of borrowed money. Indeed, the need for high exposure to debt in order to turn a profit seems to be one of the main reasons banks tend to get in trouble when economies tank.
I’m giving both Lloyds and Rio Tinto a cautious 0/5 for their approach to borrowings.
5. Degree of cyclicality
Recent weakness in the share prices of the London-listed banks and miners, teaches me not to become complacent about the cyclicality inherent in their businesses.
Cyclical firms make poor choices for a dividend-led investing strategy, I would say, and Lloyds and Rio Tinto both operate with hair-trigger cyclical characteristics.
I’m scoring both Lloyds and Rio Tinto 1/5 for their cyclicality.
Putting it all together
Here are the final scores for these firms:
| Lloyds | Rio Tinto | |
| Dividend record | 1 | 5 |
| Dividend cover | 4 | 1 |
| Cash flow | 1 | 5 |
| Debt | 0 | 0 |
| Degree of cyclicality | 1 | 1 |
| Total score out of 25 | 7 | 12 |
Rio Tinto wins this face-off, but these are two low-scoring firms. Cyclical firms such as Lloyds and Rio Tinto are two steer-clear shares for my long-term dividend strategy, so my search for a dividend champion continues.
