Why is ‘dividend cover’ important for an income investor?

Dividend cover isn’t just some arcane accounting concept, but an important idea for income investors to engage with. Christopher Ruane explains why.

| More on:
Young female business analyst looking at a graph chart while working from home

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

One of the reasons I invest, like millions of other people around the world, is the possibility of earning passive income through dividends. But such payouts are never guaranteed,. They can be cut, for example because they are ‘not covered’. Sometimes, discussion of income shares talks about ‘dividend cover’.

Here I explain what dividend cover is — and why it matters.

Paying the bills

A helpful analogy is a farmer paying rent for a plot of land he uses to grow vegetables.

The rent is the reward earned by the owner for letting the farmer use their field. Imagine that is £1,000 per year. If the farmer earns £2,000 from the crops they grow on the field, their rent is covered twice over.

But what if they only earn £500?

The rent is not covered. That does not necessarily mean they cannot pay it. But to do so, they will need to dip into other sources of money, like savings or the earnings from another field.

Earnings coverage

Normally when people talk about dividend cover, they are talking about how well the shareholder payout is covered by earnings – just like my example with the farmer above.

For example, last year’s National Grid (LSE: NG) dividend was covered 1.4 times by earnings. The power network operator reported adjusted earnings per share of 84p and the dividend per share was 58.5p.

But what if we look at basic earnings per share not adjusted ones? They were 60p per share, meaning National Grid barely covered its dividend.

Earnings are often not the same as cash flows

Why is there a difference between adjusted earnings and basic earnings?

There is a clue here to the bigger question: what are earnings?

Earnings are an accounting measure. So some things can show up in earnings that have not yet materialised as cash (and in some cases never will). Conversely, earnings may be reduced by items like depreciation, even though the last cash cost of the item being depreciated was decades ago.

A company like National Grid spends heavily on assets that are expected to last for decades. Last year, for example, it accounted for £521m of spending on depreciation and amortisation – but that does not mean it actually spent that amount on new assets during the year.

That is why as an investor I look at dividend cover by earnings, but also consider free cash flows.

Looking at free cash flows

In the earlier example, I said if the farmer “earned” £2,000 then £1,000 rent would be covered twice only. But earning £2,000 does not necessarily mean they hold £2,000 cash in their hands. Maybe they earn £2,000 by selling the crops from the field – but have to wait three months to receive the payment.

Earnings are an accounting measure. But cash flows show the hard, cold cash coming in the door or going out of it.

When it comes to dividend cover, that matters because ordinarily a company needs cash to pay dividends (unless shareholders elect to receive payment in more shares).

Last year, National Grid’s “total comprehensive income” was £1.9bn. But its free cash flows were £427m, after spending £1.7bn on dividends.

Those earnings and free cash flow numbers are miles apart. That is why I look at both when considering a share’s dividend cover.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

2 of the best US growth and dividend stocks to consider!

These heavyweight US stocks have been delivering tasty investor returns for decades. Here's why they could remain great picks for…

Read more »

Investing Articles

I reckon these 2 penny shares are hidden gems worth a closer look!

Some penny shares are well-known, whereas many others go under the radar, but that doesn’t necessarily mean they aren’t potentially…

Read more »

Investing Articles

Just released: our 3 best dividend-focused stocks to buy before August [PREMIUM PICKS]

Our goal here is to highlight some of our past recommendations that we think are of particular interest today, due…

Read more »

Investing Articles

2 FTSE 100 shares with blockbuster yields investors should consider buying

Our writer has noticed that these FTSE 100 shares offer mammoth dividend yields, and reckons investors should take a closer…

Read more »

Stack of British pound coins falling on list of share prices
Investing Articles

Down 36% and yielding 7.8%, is this FTSE 250 share a bargain?

Christopher Ruane looks at a FTSE 250 share with a sizeable dividend yield and a recent record of dividend growth.…

Read more »

Investing Articles

Is Barclays one of the FTSE 100’s best bargain stocks?

Right now, Barclays' shares are cheaper than those of FTSE 100 rival stocks Lloyds and NatWest. So should I buy…

Read more »

Happy young female stock-picker in a cafe
Investing Articles

Is a takeover offer about to boost the Rentokil stock price, and should I buy?

The Rentokil share price is up 10% on takeover rumours. Is it a stock to buy or one to be…

Read more »

Investing Articles

Here’s my Rolls-Royce dividend forecast for 2024-27!

Our writer considers whether the Rolls-Royce dividend might be reinstated in coming years, based on financial performance and stated payout…

Read more »