Is your favourite stock in the dividend danger zone?

In today’s land of low interest rates, the dividend paying stock is king. The FTSE 100 is crammed full of stocks offering right royal yields of between 4% and 7%, crushing the meagre 0.43% now paid on the average easy access savings account.

Take cover!

However, some of these yields need careful examination, because companies are struggling to fund their dividends from cash flow. New figures from investment platform AJ Bell show that forecast earnings by almost half of FTSE 100 companies cover their dividends by less than two times for 2016.

Dividend cover measures the ratio of a company’s net profits against the total sum it pays in dividends to ordinary shareholders. Russ Mould, investment director at AJ Bell, says: “Ideally you want a company’s earnings to be twice the size of the dividend payment to give it a cover of 2.0. Anything below 1.5 times earnings cover will question the sustainability of the dividend should anything go wrong. Once cover dips below 1.0 the company is having to dip into cash reserves or borrow or sell off assets to pay their dividend.”

Worryingly, average dividend cover for the FTSE 100 has now fallen to just 1.47 and for the 10 highest yielders on the index it’s a meagre 1.22. Even more concerning, six have dipped below 1.0, and a surprising number of them are very big and popular names indeed.

Troubled waters

Oil giants BP and Royal Dutch Shell are both thinly covered. They yield a generous 7.5% and 7% respectively, but dividend cover is just 0.52 and 0.43, which clearly isn’t sustainable in the longer term. Mobile phone giant Vodafone has been one of the most popular income stocks on the FTSE 100 for years and currently yields 5.5%, but forecast earnings for 2016 cover that just 0.56 times.

BHP Billiton’s yield is a less impressive 2.1% but the mining giant is struggling to fund even this, with just 0.70 cover. Insurer Admiral Group pays 5.9% but with cover of just 0.90, while financial advisers St. James’s Place pay 3.3% but with just 0.99 cover.

Dividend doubts

So are any of the stocks in your portfolio? If they are you should be a little concerned about those dividends, although you probably won’t be surprised. BP and Shell have been hanging on by the skin of their teeth, waiting for an oil price revival that has stubbornly refused to come. Crude has now climbed above $50 a barrel, although once it climbs above $55 or $60 the shale drillers are likely to come gushing back.

Vodafone’s yield also looks vulnerable, forcing the company to fund it out of reserves, and I’m hardly reassured by forecasts that it will increase to 0.63 in 2018. Although safe for now, the dividend could come under pressure if Vodafone’s profits take a hit at some point.

Dangerous game

Some other big names are also thinly covered, notably those paying the largest dividends. Direct Line, for example, yields 8% but cover is just 1.02. Taylor Wimpey yields 7.4% with cover of 1.52. Legal & General yields 6.7% with 1.46 cover. Other companies with cover below 2.0 include Marks & Spencer (6.6%, 1.45), Pearson (6.5%, 1.08), Persimmon (6.2%, 1.71) and SSE (5.9%, 1.31).

Reinvested dividends have accounted for 65% of total returns from the FTSE All Share over the past 30 years but investors shouldn’t just simply chase the highest yield they can find: it has to be sustainable as well. So check whether your portfolio is slipping into the danger zone.

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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.