What it means
A dividend is only sustainable if the business earns it. Dividend cover puts a number on the margin between what the company earned and what it distributed, and that margin is what protects the dividend when earnings fall.
A company with cover of 3.0 can suffer a two-thirds fall in profit and still earn its dividend; a company with cover of 1.2 is one moderate downturn away from paying out more than it makes. Investors who hold shares for income watch cover closely, boards use it to set dividend policy, and analysts use it to judge whether a high yield is safe or a warning.
The earnings figure should be the profit that belongs to ordinary shareholders: net income after tax, after minority interests and after preference dividends, which rank ahead of the ordinary dividend and must be deducted before the ordinary cover is calculated. Companies often present an adjusted or underlying earnings figure that strips out one-off items, and cover is often calculated on that basis, which is reasonable if the adjustments are genuine one-offs and misleading if they are recurring "exceptionals".
The dividend figure is the total for the year, interim plus final, on the shares in issue. Earnings cover has a well-known weakness: profit is not cash.
A company can report earnings that comfortably cover its dividend while generating no cash to pay it, because its profit is tied up in growing receivables and inventory, or because it must spend more than its depreciation charge to maintain its assets. Cash cover addresses this by dividing free cash flow, operating cash flow less the capital expenditure needed to sustain the business, by the dividend.
For capital-intensive businesses such as telecoms, utilities and miners, cash cover is often the more revealing figure, and a dividend that is covered by earnings but not by cash is being funded by borrowing. Real estate investment trusts and similar vehicles use their own cash-based earnings measures for the same reason.
What counts as adequate cover depends on the stability of earnings. A regulated utility with predictable profits can run cover of 1.3 to 1.7 times safely, because its earnings rarely fall far; an industrial company with cyclical earnings should hold cover of 2.0 or more; a resources company whose earnings swing with commodity prices may need 3.0 in a good year to keep the dividend through a bad one, or may adopt a variable dividend policy instead.
A company with cover persistently below 1.0 is running down its reserves, and unless it has a specific reason, such as a temporary earnings dip or a deliberate return of surplus capital, its dividend is not sustainable. For a board, cover is a policy variable.
Setting the dividend at a level that leaves target cover in a normal year, and testing it against a downside case, is the discipline that avoids the damaging cycle of an over-committed dividend followed by a cut. For an investor, cover is the first check on any yield: a high yield with low cover is usually a share price that has already fallen in anticipation of a cut, and the yield will not be received.
In practice
Real-world examples.
Example
A water utility with earnings per share of $1.50 and a dividend of $1.05 reports cover of 1.43 times, which its regulator and investors regard as normal for a business with stable, regulated revenues.
Example
A mining company's cover swings from 4.0 times in a boom year to 0.6 times in the following downturn, and it moves to a policy of a small base dividend plus a variable payment linked to cash flow.
Example
An investor screening for income rejects a share yielding 8% because its cover is 0.8 times, and later sees the dividend cut by half.
Think of it
“Dividend coverage shows how many times over the company could pay its dividend from current profits.
Formula
Calculation
Dividend cover (earnings) = Net income attributable to ordinary shareholders / Total ordinary dividends
Equivalent: Earnings per share / Dividend per share
Dividend cover (cash) = Free cash flow / Total dividends, where Free cash flow = Operating cash flow minus Capital expenditure
Preference dividend cover = Net income / Preference dividends
Payout ratio = 1 / Dividend cover
Worked example. A company reports net income of $12,000,000. It pays preference dividends of $1,000,000 and an ordinary dividend of $0.48 a share on 10,000,000 shares. Its operating cash flow was $14,000,000 and capital expenditure $6,000,000.
- Earnings attributable to ordinary shareholders = $12,000,000 minus $1,000,000 = $11,000,000
- Ordinary dividend = $0.48 x 10,000,000 = $4,800,000
- Earnings cover = $11,000,000 / $4,800,000 = 2.29 times
- Free cash flow = $14,000,000 minus $6,000,000 = $8,000,000; cash cover = $8,000,000 / $4,800,000 = 1.67 times
- Preference cover = $12,000,000 / $1,000,000 = 12 times
Downside test. If net income fell by half to $6,000,000: earnings attributable $5,000,000; cover = $5,000,000 / $4,800,000 = 1.04 times. The dividend would still be earned, just. If capital expenditure also had to be maintained at $6,000,000 and operating cash flow fell to $9,000,000, free cash flow would be $3,000,000 and cash cover 0.63 times: the dividend would require $1,800,000 of borrowing.
Comparison. A competitor with earnings per share of $0.90 and a dividend of $0.75 has cover of 1.2 times. Its dividend yield is higher, but a 20% fall in its earnings would leave the dividend uncovered, whereas the first company could absorb a fall of more than 50%.Case study
Seen in the real world.
A telecommunications company had paid a dividend of $0.75 a share for several years against earnings per share of $0.90, cover of 1.2 times, which its board described as adequate for a business with stable subscription revenues. The earnings cover looked thin but acceptable.
What the board did not routinely calculate was cash cover: the company's capital expenditure on its network ran at about 1.5 times its depreciation charge, so free cash flow per share was only about $0.60, and cash cover was 0.8 times. The dividend had been partly funded by borrowing for three years, and net debt had risen by $150,000,000.
A price war then cut earnings per share to $0.70. Earnings cover fell to 0.93 times and cash cover to about 0.5 times. The board maintained the dividend for one more year, borrowing $90,000,000 to do so, on the argument that cutting it would damage the share price.
The lenders' response was to tighten the leverage covenant at the next renewal, and the rating agency put the company on negative watch, citing "a dividend that has not been covered by free cash flow for four years". The share price fell anyway, as investors who had done the cash cover calculation sold ahead of the cut they expected.
The board cut the dividend to $0.45 the following year, restoring earnings cover to about 1.6 times and cash cover to about 1.3 times on the reduced earnings. The share price fell 12% on the announcement, less than it had already fallen in anticipation, and then stabilised.
The finance director's review for the board recommended that both earnings cover and cash cover be reported at every dividend decision, that the policy target be cash cover of at least 1.2 times on a downside case, and that the board never again treat earnings cover alone as evidence that a dividend was affordable in a business that spent more than its depreciation. The chairman's note to shareholders acknowledged that the company had been paying out cash it did not generate, and that the lesson had cost $240,000,000 of additional debt.
Watch out
Common mistakes.
- Calculating cover on net income before deducting preference dividends and minority interests, which overstates the earnings available to ordinary shareholders.
- Relying on earnings cover alone in a capital-intensive business, where the cash needed to maintain the assets can leave a dividend covered by profit but not by cash.
- Reading adequate cover in a good year as evidence the dividend is safe, without testing it against the fall in earnings the business could plausibly suffer.
Questions
People also ask.
What is the difference between dividend cover and the payout ratio?
They are reciprocals. Cover of 2.5 times is a payout ratio of 40%; cover of 1.25 is a payout of 80%. Cover expresses the margin of safety; the payout ratio expresses the share of earnings distributed.
What is a good level of dividend cover?
Above 2.0 times is generally comfortable for a company with cyclical earnings; 1.3 to 1.7 is normal for utilities and other stable businesses; below 1.0 means the dividend was not earned. The right level depends on how far earnings could fall.
Why does cash cover matter?
Because profit can be tied up in working capital or consumed by capital expenditure above depreciation, so that a dividend covered by earnings still has to be borrowed. Free cash flow divided by dividends shows whether the business generated the money it paid out.
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