Rising interest rates are creating some great opportunities in dividend shares. But investors need to proceed with caution – a high yield can be a sign the market thinks the payout is unsustainable.
So how can investors identify businesses that are likely to keep returning cash to shareholders in future? And which are the safest dividend stocks from the FTSE 100?
Passive income
Shareholder returns are only ever as secure as the earnings of the underlying business. If a company’s earnings fall for a prolonged period, this is going to affect its ability to return cash to its shareholders.
So when assessing dividend shares, the most important thing to judge is what the company’s future earnings will be. This is the tricky bit, but there are some tools investors can use.
With a recession on the horizon, looking at a company’s history can offer valuable insights. Specifically, it can be useful to know how it has performed in previous downturns.
If a business has a history of generating strong earnings and paying out in difficult economic environments, this might indicate it can do so in future. If not, this might be a concern.
Equally, how much of a company’s free cash it returns to its shareholders via dividends is important. A company that returns all of its cash might not be able to maintain its payments if its earnings slip.
There’s more to assessing a company’s dividend safety than these two metrics, but I think they give investors a good starting point. So which FTSE 100 stocks fare well according to these metrics?
FTSE 100 stocks
Diageo is a typical dividend stock. It enjoys steady demand for its products and this allows it to pay a steady return, which has increased annually for more than 20 years.
Over the last decade, the company’s distributions have grown by an average of 5% per year. And paying out just 60% of its free cash flow means a bad year shouldn’t automatically lead to a cut.
The company is currently facing a lawsuit from Sean Combs over its marketing of their joint ventures. This creates uncertainty and an element of risk, but I see the falling share price as an opportunity.
By contrast Croda International is the opposite of a typical dividend stock. It is highly cyclical and its earnings fluctuate a lot in different economic environments.
This makes the prospect of a recession a risk and the company announced last month it expected profits to come in lower than previously anticipated. But I don’t see a threat to the dividend.
Like Diageo, Croda has over 20 years of consecutive annual dividend increases. And with its payments covered by its free cash flow, I expect the company to maintain its shareholder distributions.
Which stock to buy?
Neither Diageo (2.33%) nor Croda (1.95%) has the most eye-catching yield. But I think these are among the FTSE 100 stocks least likely to cut their dividends any time in the near future.
Of the two, I’d prefer Croda. I see the current share price as a real opportunity to exploit some undue pessimism around the stock, so I’ll be looking to make an investment when I have cash available.
