Dividend cover at these FTSE 100 firms offers little margin of safety.
Perhaps the oldest and most well-established form of investing is investing for income (rather than for capital gains).
Since the 13th Century, investors have been handing over their capital to governments and businesses in return for a share of any ongoing profits.
In today's high-speed financial world, shares are bought and sold in tiny fractions of seconds by high-frequency trading algorithms backed by massive computing power. Despite this frenzied and faceless approach to turning a profit, there is still plenty of room for private investors seeking to boost their incomes by collecting dividends -- the regular cash payouts to shareholders from businesses.
Indeed, high-yield investing -- picking shares and funds that pay generous dividends -- has been an increasingly popular investment style since the Fifties. However, one lesson that high-yield investors must learn is that the highest dividends usually (but not always) come with the highest risk.
One simple way for investors to gain confidence when picking high-yield shares is to ensure that any dividend is comfortably covered by earnings.
To do this, you divide a company's earnings per share by its dividend per share. If this figure is less than one, then the dividend is not fully covered by earnings and, therefore, could well be under threat. On the other hand, dividend cover approaching two -- or even higher -- provides a solid margin of safety.
With dividend cover of two, earnings could halve and the dividend would still be fully covered (but could still be cut, of course). Personally, I wouldn't rely on any dividend that isn't covered by earnings with at least a 30% margin of safety. In other words, I would look very unfavourably on dividend cover below 1.3.
Checking bumper dividends
To find out how many firms fall into this category, I screened for companies with market values above £1 billion and dividend yields of 4.5% or more. This revealed a total of 37 big businesses -- all members of the FTSE 100 or FTSE 250 -- paying handsome dividends.
I then checked the dividend cover of these 37 firms and found that it ranged between 0.25 and a whopping 4.5. However, these are historic figures and, therefore, may not reflect dividend payouts for this and future years.
I then sorted these 37 candidates to look for well-known names with high dividend yields, let down by low dividend cover. This sort identified 10 firms with dividend cover below 1.3.
Here are three FTSE 100 companies with low dividend cover that offer little in the way of margin of safety to income-seeking investors:
1. United Utilities
Of my three 'low-cover companies', United Utilities (LSE: UU) is probably the lowest-risk investment.
In a trading statement released this morning, United confirmed it was "on track to deliver a good underlying financial performance for the year ending 31 March." It expects full-year revenue to increase by 3% to 4%.
However, thanks to higher capital spending, United forecasts underlying operating profit to be lower in its second half than in the first. Also, net debt is "slightly higher" than the £5 billion reported as at 30 September.
As I write, United's share price is 620p, valuing the group at £4.2 billion. Right now, it offers a dividend yield above 4.9%, covered only 1.17 times. In other words, a drop in earnings of 14% to 15% would leave United's dividend uncovered.
Then again, as a regulated utility with a large, established customer base, United has strong, predictable earnings. Thus, I do not expect to see any dividend cuts from United now or in the immediate future.
2. Standard Life
Founded in 1825, and with 1.5 million private shareholders and 6.5 million customers worldwide, Standard Life (LSE: SL) is a household name.
When Standard Life reported its 2011 results earlier this month, it raised its dividend by 6%. Alas, with a full-year dividend of 13.8p and earnings per share of 12.9p, last year's dividend was not fully covered by earnings.
Today, with its share price at 233.5p, Standard Life is valued at £5.6 billion and offers a dividend yield of 5.8%, covered just 0.94 times. Despite its sub-par dividend cover, I suspect that Standard Life will not cut its dividend in 2012. After raising its dividend every year since it floated in mid-2006, I imagine that Standard Life's board has a point to prove and, therefore, won't trim this payout.
3. Man Group
The least-known name of my three is Man Group (LSE: EMG), the world's largest listed manager of hedge funds. Three weeks ago, I wrote about Man's fat dividend, which, at 10%, was the highest in the FTSE 100.
Unfortunately, Man's dividend is only two-thirds covered by earnings, with dividend cover of just 0.66. However, it does have $550 million of surplus capital which it could use to keep its dividend high while it waits for financial markets and its earnings to recover.
As I write, Man shares trade at 136p, valuing the group at £2.6 billion. Man aims to pay out 22 cents (13.8p) in dividends in 2012, for a dividend yield of just over 10%. However, for this payout to be fully covered, Man's earnings would have to soar by 50% this year.
Hence, of these three Footsie firms, I consider Man's payout to be shakiest.
In summary, while it's all very well banking a high dividend today, what matters most is what the payout will be next year, the year after, and beyond. By paying close attention to companies' dividend cover, you can steer clear of those firms most at risk of cutting their cash payouts in the coming years!
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