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3-Point Income Checklist: Should You Buy Foxtons Group PLC, Lancashire Holdings Limited Or Plus500 Ltd?

It’s easy for income investors to play it safe with the usual FTSE 100 dividend names, but sometimes a look at the broader market can reveal some income gems which are overlooked by the majority of investors.

In this article, I’m going to take a look at three such stocks: Foxtons Group (LSE: FOXT), Lancashire Holdings (LSE: LRE) and financial firm Plus500 (LSE: PLUS).

1. Income growth

When investing for income, two important numbers are the stock’s forecast yield, and the historic rate of dividend growth, preferably over at least five years.

That’s easy enough for a FTSE 100 stalwart like Imperial Tobacco, but it’s not so easy for these three firms, as Foxtons and Plus500 have only been listed since 2013.

To get around this, I’ve calculated the growth rate based on the past two years’ payments, including special dividends, plus the latest City forecasts for 2015 and 2016.

However, although forecasts are a useful guide, bear in mind that they can change:

Company

2015 forecast yield

2013-16 forecast dividend growth rate

Foxtons

4.7%

+21%

Lancashire Holdings

10.2%

+11.3%

Plus500

5.4%

+18.3%

Unusually, all three firms paid special dividends last year, boosting their payouts. This may not always be the case — disaster insurer Lancashire, in particular, is unlikely to deliver consistent dividend growth.

2. Dividend cover

High dividend yields are only really attractive if they are sustainable: an ordinary dividend yield of more than 6%, for example, typically indicates some kind of risk.

The most widely used measure to test the affordability of a firm’s dividend is earnings cover, where the payout is compared to earnings per share.

For most businesses, I usually look for cover of at least 1.5 times, preferably closer to 2:

Company

2015 forecast dividend cover

Foxtons

1.3

Lancashire Holdings

0.9

Plus500

1.7

Plus500 is expected to have the strongest level of dividend cover this year, while Foxtons is a little weaker than I’d like.

Although Foxtons’ net cash balance means that the risk of a cut to the ordinary payout is low, the estate agent could reduce its special dividend if the London property market fails to pick up after the General Election.

Lancashire is a special case — soft conditions in the insurance market and a lack of major disaster claims last year mean that the firm has plenty of surplus cash, so is returning it to shareholders. The lack of earnings cover isn’t an issue, here, in my view.

3. Free cash flow cover

Earnings cover is important, but the very best dividends are those paid with surplus cash generated by the business.

The simplest way to measure this is by calculating the free cash flow cover for a dividend, which I’ve done here using last year’s results:

Company

2014 free cash flow cover

Foxtons

1.02

Lancashire Holdings

0.87

Plus500

1.96

Plus500 is a clear winner, in my view.

While Foxtons paid out virtually every penny of its free cash flow in 2014, Plus500 paid out a prudent 50% of free cash flow, saving the rest for future use.

My dividend pick

My pick of these three would be Plus500, which appears to offer a well-covered dividend with decent growth prospects.

Foxtons looks the least appealing, to me, while Lancashire is only really suitable for investors who can cope with unpredictable variations in income from year to year.

Your view may vary -- but before making a decision to buy or sell, I would suggest testing the dividends in your portfolio against the five golden rules of dividend investing.

These simple rules could protect you from painful losses and frustrating stagnation: you can find full details in "How To Create Dividends For Life".

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.