Dividend Coverage Ratio Explained: Avoid Painful Dividend Cuts
If you’re reading this, it’s because you want 2 things:
- Reliable income.
- To make your money grow.
One of the best ways to achieve both of those is by following my favorite investing strategy:
Dividend growth investing.
If you don’t know what this is, it consists of building a portfolio of high-quality stocks.
These stocks will pay you dividends which will likely increase every single year.
The key to being successful with dividend growth investing is being able to know if a stock will increase its dividend.
And more importantly…
How to avoid painful dividend cuts!
Dividend Cuts & Suspensions – An Investor’s Worst Enemy
As I write this, we’re in the middle of the coronavirus market crash.
In times like these, companies make fewer sales, earn less money, and are sometimes forced to cut or eliminate their dividend.
The last thing you want is to experience a dividend cut…
Not only will you lose income, but the stock prices of companies tend to plummet after a dividend cut announcement.
So…
How can you avoid dividend cuts and ensure you’ll get reliable, growing dividends which should also grow every year?
One of the easiest ways to determine this is the dividend coverage ratio. (This is similar to the payout ratio – more below).
What Does Dividend Coverage Ratio Mean?
The dividend coverage ratio (also called dividend cover) measures how well a company’s earnings cover the dividend.
You see, buying a stock is no different from buying a business.
Warren Buffet always talks about this in his many talks and interviews. In his opinion, investors should focus more on the underlying business and not as much on the stock price.
As one of the world’s richest people, I’d say he knows a thing or two! 😉
When you buy a piece of a business, you should understand some of its important metrics.
The dividend coverage ratio is one of those metrics.
Dividend Coverage Formula
So how can you calculate the dividend coverage of a stock?
It’s simple.
First, you need to know two values about a stock:
- The dividend amount per share per year.
- The earnings per share per year.
I say per year because earnings can sometimes fluctuate between quarters. Looking at yearly figures evens everything out and gives you a more accurate result.
Once you have those two numbers, plug them into this formula:
Dividend Coverage Ratio = Earnings per Share / Dividends per share
This will tell you how many times over a company can cover its dividend with its earnings.
(Note: You could also use net income, or even the total amount of dividends paid. However, it’s a lot easier to find “per share” numbers, so that’s what I recommend you use)
Let me give you an example.
In 2019, The Coca-Cola Company (KO) made $2.09 in earnings per share (EPS).
It also paid $1.6 in dividends per share.
If we plug in those values into the formula, this is what we get:
Dividend Coverage Ratio = 2.09 / 1.6 = 1.3
In other words, they were able to cover the dividend 1.3 times over.
That’s not too impressive…
If they had a bad year and their earnings dropped, they would not be able to afford to pay the dividend using earnings only.
Ideally, the dividend coverage ratio should be nearer to 2.
This leaves companies plenty of wiggle room and is a great indicator that the dividend is safe.
And as investors who want safe and growing income, that’s what we care about!
Is It the Same as the Dividend Payout Ratio?
Sort of.
They both measure the same thing, really:
How well covered a dividend is compared to earnings.
The main difference is in the formula. To calculate the payout ratio, you just have to flip the numbers around like so:
Payout Ratio = Dividend per share / Earnings per share.
Let’s use the example of Coca-Cola again.
Payout Ratio = 1.6 / 2.09 = 0.77 = 77%
I personally prefer this way of looking at it, as people inherently understand percentages better.
It’s how we’re wired.
It’s also the more widely spread way of displaying this metric, so I recommend you use it too.
In the case of the payout ratio, it should be below 100%, but ideally below 60%.
By the way, a dividend coverage ratio of 2 is the same as a payout ratio of 50%.
Which Stocks Have the Best Coverage?
At this point I bet you’re thinking:
“OK, so I need to find stocks with a high dividend coverage ratio.”
And you’d be absolutely right!
This is one of the most important metrics – or signs – that a stock’s dividend is safe.
If a company has a low dividend coverage, it’s putting a lot of pressure on their earnings to be able to pay it…
On the other hand, if a company has a higher coverage (or lower payout ratio) it can afford some bad years and still pay and increase its dividend.
This is actually very difficult to achieve…
Average companies can’t do it.
Only very high-quality businesses with excellent management teams are able to do it consistently.
What are these companies called?
Blue chip stocks.
Specifically, dividend growth stocks. I talk more about them in this article, where I also reveal 3 high dividend blue chip stocks.
A portfolio full of them will ensure you keep getting paid an income and that your money keeps growing.
Note: This article originally appeared at Modest Money. The author is Richard Torres.
Category: Dividend Stocks
