There are many high-yielding dividend stocks in the FTSE 100, but it’s important to remember that some its constituents make better income investments than others. Finding good income stocks involves more than just picking high-yielding companies as you have to be sure that the earnings outlook is promising and the payout is sustainable, otherwise you could find yourself looking at both capital losses and dividend reductions.
Indeed, it’s often best to look for quality companies with strong underlying fundamentals and robust dividend cover. And this is why I’m concerned about Vodafone (LSE: VOD) as an income investment.
Not fully covered
Shares in Vodafone support a dividend yield of 5.9%, but the current payout is not fully covered by earnings. In fact, the company has failed to fully cover its dividends by either adjusted earnings or free cash flow (after spectrum payments) for the past three years.
And although the company’s cash flow situation has improved considerably with the end of its massive Project Spring investment programme, its steadily rising debt level remains a major concern. Net debt has risen from £13.7bn in 2014 to £32.1bn by end of September 2017, and seems set to rise further in the medium term, largely driven by incremental capital expenditure in broadband and likely future spectrum investments.
On the earnings front, things look somewhat better following a recent trading update which showed the company on course to deliver around 10% growth in organic adjusted EBITDA in 2017/8. It has made great strides in the home broadband market, where it has been a latecomer, and has attracted a record number of new customers in a number of European markets.
But still, City analysts reckon that it won’t be until at least 2020 that Vodafone will generate sufficient earnings to cover its dividend. That’s quite some time ahead, and the company could encounter some unexpected hiccups along the way.
A better buy?
Instead, I reckon mining giant Rio Tinto (LSE: RIO) may be a better income investment with its 5.6% prospective yield. With the recovery in commodity prices, fundamentals are in a much better shape as evidenced by its recent strong set of results.
Sure, the company operates in a cyclical industry where it is exposed to volatile commodity prices, and it’s exactly because of this that investors don’t typically look to mining stocks for income.
Low cost producer
But I reckon a blanket ban on the sector may not be wise, because that would be to ignore the fact that low cost producers, such as Rio Tinto, can be significantly more reliable dividend payers than their sector peers. Being at the very low end of the cost curve, Rio Tinto benefits from strong and stable free cash flows, which are protected by its wide profit margins.
With an EBITDA margin of 44% and net debt of just $3.8bn, Rio Tinto has plenty of room to manoeuvre before it has to resort to cutting its dividend. What’s more, dividend cover is robust, with last year’s free cash flow of $9.5bn covering its annual dividend of $2.70 per share by 1.83 times.
It goes to show that if you pick the right companies, you can set yourself up to profit handsomely from both a steady stream of dividend income and strong capital gains, whichever sector the companies belong to.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.