Beware the "yield trap".
Understandably, income investors study dividend yields quite closely. After all, a share on a dividend yield of 5% will pay out twice as much as a share rated on a more miserly yield of 2.5%.
Some investors look at historic yields; some at forecast (or "prospective") yields. It's not a deal-breaker either way, although personally I prefer forecast yields.
But here's the kicker: either way, those yields can be unexploded mines, lurking for the unwary. Looking at yield on its own, in short, can quickly introduce you -- painfully -- to the meaning of the term "yield trap".
The yield trap is simply explained. You buy a share, attracted by the high yield. But the dividend is then cut, or cancelled -- leaving you without the anticipated income. Worse, unsupported by the payout, the share price usually falls as well, leaving you also nursing a capital loss.
Let's see it in action.
Company A pays out 9 pence a share, with shares changing hands for 100 pence per share. So the dividend yield -- which is the dividend per share, divided by the share price, and multiplied by a hundred to turn it into a percentage -- is 9%.
But that 9 pence is unsustainable. Company A then halves its dividend, slashing investors' income. What happens to the yield? If the share drops to -- say -- 80 pence, the historic yield the becomes 5.6%. The "yield on cost" figure, of course, is 4.5%.
How, then, should investors spot potential yield traps? The most obvious reason for slashing the dividend is that the business simply hasn't got the money to pay it.
The business's earnings, in short, aren't large enough to support a distribution to shareholders at historic levels.
Put another way, actual earnings per share aren't sufficiently when large compared to the anticipated dividend per share.
Which is where the notion of 'dividend cover' comes in: earnings per share divided by dividend per share.
Interpret with care
Now, dividend cover shouldn't be followed blindly. Some businesses -- such as utilities, for instance -- can quite happily operate with lower levels of dividend cover than more cyclical businesses. Other businesses -- such as REITs -- must pay out a fixed proportion of earnings as dividends, so again a low level of dividend cover is the norm.
Still other businesses have very high levels of dividend cover, because they are growing -- and therefore retaining earnings for future investment -- rather than paying them out as dividends.
But as a broad brush generalisation, a ratio of close to one is definitely the danger zone. A ratio much bigger than two indicates a certain parsimony. Personally speaking, a ratio of 1.5-2.5 is usually what I'm looking for.
The table below highlights five shares with dividend cover well into the danger zone that I've mentioned. They're all big names, and -- given their yields -- are popular with income investors. And in each case, I've shown the last full year's earnings per share and dividend, yield and dividend cover.
There are shares with lower levels of dividend cover, to be sure -- but they tend to be REITs, or other special cases. The five highlighted have fewer extenuating circumstances, and seem to me to be more in danger of reducing their payout.
|Company||Forecast yield %||Full-year earnings per share||Dividend||Dividend cover|
|Standard Life (LSE: SL)||6.6%||13p||13.8p||0.9|
|United Utilities (LSE: UU)||5.3%||35.3p||32.1p||1.1|
|Hargreaves Lansdown (LSE: HL)||4.7%||20.3p||18.9p||1.1|
|Admiral (LSE: ADM)||7.7%||81.9p||75.6p||1.1|
|Aviva (LSE: AV)||10.1%||5.8p||26p||0.2|
So should holders of these shares be worried? There isn't sadly, a clear-cut answer -- a fact that highlights the importance of looking at the underlying data quite carefully, and considering the full set of circumstances.
Reading the runes
Standard Life, for instance, seems clear-cut, on both a historic and forecast basis: by my reckoning, the dividend is genuinely sailing close to the wind.
But Hargreaves Lansdown and Admiral, though, complicate matters by distinguishing between an ordinary dividend and a more discretionary extra 'special' dividend. But either way, a cut is a cut, and both firms have a level of dividend cover just above one, implying that there's very little margin of safety.
United Utilities may surprise you, depending on which stock screener you use. I've gone back to the annual accounts, and used the underlying earnings per share of 35.3p, described by the company as "providing a more representative view of business performance" -- implying the level of dividend cover that I've shown. Plug the statutory basic earnings per share of 45.7p into the calculation, though, and the dividend cover is a healthier 1.4.
And finally, there's Aviva, where the opposite problem applies. On a statutory basis, the earnings per share of 5.8p delivers a disturbing level of dividend cover of 0.2. Throw in the company's own preferred definition of earnings per share, and a healthier level of earnings of 53.8p emerges, giving a dividend cover of almost 2.
What do experts do?
One investor well used to evaluating the prospects of income shares, of course, is Neil Woodford, who looks after two of the country's largest investment funds and runs more money for private investors than any other City manager.
Take a glance at some of his largest holdings, and you won't find any of these five shares -- indeed, he takes a dim view of both utilities and many financial stocks.
So where is he investing instead? As it happens, this free special report from The Motley Fool -- "8 Shares Held By Britain's Super Investor" -- profiles eight of his largest holdings, and explains the investing logic behind them.
Is he worth listening to? Well, on a dividend re‑invested basis over the 15 years to 31 December 2011, Mr Woodford has delivered a spanking 347% return, versus the FTSE All-Share's distinctly more modest 42% performance. Which to my mind, speaks for itself.
So why not download the report? It's free, so what have you got to lose?
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> Malcolm owns shares in Aviva, but none of the other companies mentioned. The Motley Fool owns shares in Hargreaves Lansdown.