Rushing out to buy the stocks with the highest dividend yields available is a risky game. Indeed, chasing yield can end up costing you more than you stand to make, although most of the time it’s almost impossible to tell which companies are most likely to cut their dividends.
To try and help investors from cashing unsustainable dividend yield, investment bank Société Générale publishes a monthly list of “high dividend risk companies” across developed markets.
Firms that make it onto the list have a dividend yield of 4% or more and a lower-than-average Merton score — a measure of credit risk and financial stability. This month Premier Farnell (LSE: PFL) and Glencore (LSE: GLEN) top the list, while Fresnillo (LSE: FRES) tops the bank’s list of the most overvalued UK companies.
Premier Farnell supports a dividend yield of around 8% at present and trades at a forward P/E of 9.5. Traditionally, Premier has paid out the majority of its profits to shareholders. The company’s dividend cover ratio has averaged 1.2 for the past five years. Nevertheless, Premier’s earnings have collapsed by around 40% since 2012 and management issued another profit warning during June. As Premier restructures to improve profitability, management could be forced to axe the dividend to save cash.
Glencore is under severe pressure to slash its dividend payout and key the cash for debt repayments. City analysts are becoming extremely concerned about the company’s $50bn debt pile. If commodity prices don’t recover soon, Glencore could find itself being forced to sell off assets to repay creditors. Even though Glencore’s dividend yield of 9% may be the best in the FTSE 100, it should be avoided — it might not be around for long!
Société Générale believes that Fresnillo should be avoided as it is one of the most overvalued companies trading on the London market. The company currently trades at a forward P/E of 55, making it one of the most expensive companies in the metals and mining sector. What’s more, Fresnillo also looks expensive on price to sales, price to book and EV to EBITDA ratios.
Investors should avoid Premier, Glencore and Fresnillo. But Société Générale believes that Persimmon (LSE: PSN) and Pearson (LSE: PSON) are two of London’s best income stocks. Using a similar method to the high dividend risk screen mentioned above, Société Générale’s models show that Pearson and Persimmon’s dividend yields are well covered by earnings and the two companies have solid balance sheets, which can withstand sudden shocks.
According to City forecasts, Persimmon’s shares will support a yield of 5.3% next year, and the payout will be covered 1.5 times by earnings per share. Pearson currently supports a yield of 4.9%.
Moreover, both companies have cash-rich balance sheets with low levels of gearing. Pearson’s net gearing is 42%, and Persimmon has a net cash balance of £272m.
Rupert Hargreaves 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.