Before I say which, it’s worth pointing out that income investors need to know how likely a company is to stump up its dividend yield. When a company is struggling, dividends are usually the first to go.
Things you need to watch for include: levels of free cash flow; dividend cover; and net gearing, or debt. Free cash flow is the money left over after costs and is important because a business usually diverts this towards shareholders. Dividend cover is the number of times that dividends per share are covered by earnings per share. A number below 1 means that dividends are not covered by earnings and anything under 1.3 is risky. The weight of excessive debt can also depress dividend payments.
Vodafone, with a headline dividend yield of 5.2%, falls squarely into the description of a globally-diversified household brand that makes it a favourite of the UK’s richest fund managers.
But for income investors, the telecoms giant is a contrarian pick. Years of relative stability turned to turmoil in 2018 and since then the share price has lost half its value. Prices rebounded in July 2019 when Vodafone gained regulatory approval for an €18.4bn takeover of Liberty Global assets in Germany, Hungary, Romania and the Czech Republic.
Net gearing of 56% compares well to its telecoms rivals, but free cash flow is at a premium because of its acquisition strategy.
I’m also wary because relatively high dividend payouts of between 5% and 7% in the last five years have not been covered by earnings. Then May 2019 marked the end of a 20-year rising streak when Vodafone cut its dividend by 40% to pay down its debt mountain.
Management seems to have a grasp on the situation — a 5G mast-sharing deal with O2 means costs have been cut, for example — but margins are excessively tight and competition fierce across home broadband and mobile data.
Add falling year-on-year revenues, lower earnings per share, a €2.6bn loss in the latest 2019 results and the fact you’ll pay a premium of a stonking 36 times earnings, and Vodafone has me well and truly scared off.
The Lloyds share price looks like an absolute bargain at the moment. The bank has rising pre-tax profits and higher earnings per share year-on-year, with a headline dividend yield of 6.5%, while the shares trade at a discount to the 53p net asset value per share.
Its 86% net gearing is on par with sector rivals HSBC and Royal Bank of Scotland, comparing unfavourably only to Barclays.
The shares are seriously undervalued according to a value investing measure known as the Q ratio, and trailing and forward price-to-earnings ratios are attractive at 9.4 and 6.9 times earnings.
But half-year results in July spooked investors. They showed a single-digit decline in net income and bosses had to set aside more than the market expected to cover claims from the PPI mis-selling scandal. I think share price declines are an overreaction, especially since the bank was able to cut operating costs across the first half.
CEO António Horta-Osório has also sanctioned a 5% increase in the next interim dividend, and it’s covered 1.8 times by earnings. City analysts say Lloyds is a buy. This time, I agree.
Tom holds no stake in the companies mentioned. The Motley Fool UK has recommended Lloyds Banking Group. 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.