Why dividend yield may not tell the full story

Head of Markets at interactive investor Richard Hunter explains why you should look beyond a company's dividend yield, here's what income seekers need to add to their investing arsenal.

Even after the recent hike to 0.75%, the UK interest rate environment is at historically low standards.

The average interest rate in the UK since the Bank of England's formation in 1694 is a fraction under 6%. Prior to the financial crisis of 2008/09, the lowest ever rate had been 2%, a level hit a few times between the 1850s and the 1880s, and then not again until 1932 and 1939.

During the past 10 years of ultra-low interest rates, an increasingly important issue for investors has been the search for yield, since they are earning next to nothing on their cash (and actually losing value if inflation is factored in). 

As such, shares have been in particular focus. Despite the generally higher risk, the FTSE 100 for example yields 3.8% on average. 

Many investors will be drawn to big companies that pay out high levels of income. But don’t take the dividend yield in isolation as a reason to invest, it may not tell the full story. 

Dividend yield is calculated as the amount of the dividend divided by the share price, expressed as a percentage.

This is important because, all things being equal, if a share price falls the dividend yield will rise. A seemingly healthy dividend yield could, therefore, be the result of a falling share price – and a company which is potentially in trouble.

In addition, whilst a yield of 5% may seem punchy and attractive, you should look at it in the context of the company's dividend cover.

Dividend cover is effectively the number of times the company could pay a dividend to shareholders from current earnings. Generally, a dividend cover of 1.5 or above is seen as perfectly acceptable, whereas anything below 1 is indicative that dividends are being paid from reserves, which ultimately is unsustainable. Although, by the same token the negative figure could be the result of an exceptional item which has reduced earnings, such as an acquisition.

A few random examples illustrate this point.

Source: *Proquote, ** Digital Look, 9 August 2018

Legal & General Group, on the face of it, is paying a generous dividend and also has the payment well covered. Looking ahead, on the other hand, the forecast dividend yield for Admiral Group (which is an estimate based on future earnings), is high but the cover dangerously low.

Equally, the recent decline in the Card Factory share price has bumped up the dividend yield, although this is not comfortably covered (let alone the additional, special dividend which the company had previously announced prior to the latest price decline).

This method is generally a good guide, but there will always be some exceptions.

Source: *Proquote, ** Digital Look, 9 August 2018

Taking the case of BP (it is a similar story also at Royal Dutch Shell B), on the face of it, the dividend cover figure should cause some alarm as to its sustainability.

But oil companies have immensely complex balance sheets and ways of reporting earnings, so investors tend to reflect more on the company’s associated comments on their dividend policy.

In the case of BP, there was a time during which the ongoing payment of the dividends seemed in doubt as the company paid tens of billions of dollars in fines and compensation following the Gulf of Mexico oil spill disaster. However, the Chief Executive of the company made the continual pledge (which was kept) that in terms of financial performance, the dividend was the top priority and that it would not be removed.

Even so, considering the dividend cover figure is an important (and often overlooked) part of an investor's armoury for the income seeker, where the yield figure alone may not reflect the full picture of the financial health of a company.