The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.
There are a variety of ways to judge future dividends, and today I am looking at Direct Line Insurance Group (LSE: DLG) to see whether the firm looks a safe bet to produce dependable payouts.
Forward dividend cover
Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:
Forward earnings per share ÷ forward dividend per share
Direct Line is expected to produce a dividend per share of 12.6p for 2013, according to City analysts, while earnings per share is forecast to come in at 17.8p. This produces dividend cover of just 1.4, far short of the widely considered security benchmark of 2 times forward earnings.
Free cash flow
Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:
Operating profit + depreciation & amortisation – tax – capital expenditure – working capital increase
The insurance giant — which was spun off from Royal Bank of Scotland and listed on the London Stock Exchange last October — reported negative free cash flow of £1.59bn in 2012, worsening from the negative readout of £960m the previous year.
Although profit rose to £461.2m last year from £421.9m in 2011, the most notable factor in the cash flow deterioration was a large movement in working capital — an increase of £1.99bn in 2012 compares hugely with a £1.29bn uptick seen in the previous 12 months.
This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:
Short- and long-term debts + pension liabilities – cash & cash equivalents
___________________________________________________________ x 100
Direct Line posted a negative gearing ratio of 25.5% last year, worsening from a negative readout of 22.6% in 2011. Total debt rose to £787.5m from £504.9m, although cash and cash equivalents increased to £1.51bn from £1.38bn. Still, it was a massive reduction in shareholders’ equity — to £2.83bn from £3.87bn — which prompted gearing to rise in 2012.
Buybacks and other spare cash
Here, I’m looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.
Rather than splash the cash, the recently spun-off insurer continues to streamline its operations in order to shore up the balance sheet. Indeed, Direct Line announced in June that it plans to double the gross annual cost saving target of £100m that was originally announced last August, a move that involves the slashing of some 2,000 jobs.
Cracking dividend yields but uncertainty remains
Direct Line currently provides a dividend yield of 5.6% in 2013, far above the prospective 3% average for the FTSE 250. The company is a gargantuan presence in the car and home insurance markets, operating across a multitude of sub-sectors and which is also making headway on the continent.
However, the firm’s ambitious transformation plan will take some time to bed in and make a significant impact on earnings, a situation likely to keep the balance sheet under pressure. Rising competition across its main markets could put a spanner in the works for its earnings outlook and dividend prospects. Investors must weigh up the potential for juicy yields against this risky backdrop.
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> Royston does not own shares in Direct Line Insurance Group.
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