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I predicted Pearson plc’s dividend cut with these simple rules

Pearson (LSE: PSON) has paid or maintained its dividend every year for over two decades, so next year’s ‘rebasing’ (read that as ‘cut’) may come as a surprise to some long-term shareholders. It really shouldn’t, though.

Investors paying attention should have seen the potential cut a long time ago. I warned investors to steer clear of Pearson’s dividend in this article only a month ago. Since then, the shares are 28% down with no sign of recovery.

The following rules helped me dodge Pearson and they could help you avoid the next dividend disappointment.

Rule 1: Avoid businesses in strategic flux

Businesses can only pay out cash if it’s truly surplus to requirements, or else endanger the competitive position through a lack of investment. Therefore, the more reliable a company’s cash flow, the more it can pay out in dividends.

Pearson has been undergoing a strategic shift for a number of years, moving away from print textbooks towards digital educational supplements. It also sold off all of its journalistic assets, including The Financial Times and French media group Les Echos.

This creates uncertainty. When a company changes direction its calculations might point to a likely increase in cash flow and profits, but this isn’t guaranteed. Pearson’s profitability and cash flow carried on falling, in part due to this strategic shift, until it could no longer handle the hefty dividend.

Rule 2: Check the macro picture

Oftentimes, a company can influence its own future. Top-quality products, sales teams and customer service can create a virtuous loop of growth, facilitating increasing payouts.

Unfortunately, even the best of businesses can struggle if their customers just don’t want to buy that type of product anymore – from anyone. Therefore, it’s key to consider the state of the company’s industry before committing capital to a long-term income investment.

In its October trading update, Pearson reported a tough market, with fewer North Americans enrolling in vocational courses due to a high employment rate. “Inventory corrections” from suppliers followed, denting sales. The driving factors behind the drop didn’t seem likely to reverse in the short-term, so it should come as no surprise the region has continued to struggle.

Rule 3: Analyse earnings and cash flow

The dividend paid should ideally be well covered by earnings per share. Similarly, the dividend should also be well covered by free cash flow.

Pearson’s profits have been falling for years now, but earnings per share has been propped up by a number of disposals. This is why checking both cash flow and earnings is essential.

The company generated only £211m cash from operations in 2015, yet paid out £423m in dividends. This is clearly not sustainable. Cash flow equally didn’t look great on a last-12-months basis, clocking in at £262m.

Rules are there to be broken

If there were truly a set of quantitative rules to beat the market I reckon we’d have found it by now. Therefore, maybe I should be referring to the above as guidelines, not rules.

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Zach Coffell 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.