What is Dividend Coverage Ratio? How to Avoid Painful Dividend Cuts

 If you’re reading this, it’s because you would like 2 things:

1. Reliable income.
2. To make your money grow.

One of the simplest ways to realise both of these is by following my favourite investing strategy:

Dividend growth investing.

If you don’t know what this is often , it consists of building a portfolio of high-quality stocks.
These stocks can pay you dividends which can likely increase every single year.
The key to being successful with dividend growth investing is having the ability to understand 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 within the middle of the corona-virus market crash.
In times like these, companies make fewer sales, earn less money, and are sometimes forced to chop or eliminate their dividend.
The last item you would like 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 are you able to avoid dividend cuts and ensure you’ll get reliable, growing dividends which should also grow every year?

Related:

Dividend rate of growth – the way to Grow Your Wealth Without Lifting a Finger

One of the simplest ways to work out this is often the dividend coverage ratio.
(This is analogous 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 not any 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 the maximum amount 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 bit of a business, you ought to understand a number of its important metrics.
The dividend coverage ratio is one among those metrics.

Dividend Coverage Formula

So how are you able to calculate the dividend coverage of a stock?

It’s simple.

First, you would like to understand two values a few stock:

1. The dividend amount per share per Year
2. The earnings per share per year .

I say per year because earnings can sometimes fluctuate between quarters. watching yearly figures evens everything out and provides you a more accurate result.
Once you've got those two numbers, plug them into this formula:

Dividend Coverage Ratio = Earnings per Share / Dividends per share

This will tell you ways repeatedly over a corporation can cover its dividend with its earnings.
(Note: you'll also use net , or maybe the entire amount of dividends paid. However, it’s tons easier to seek out “per share” numbers, so that’s what i like to recommend you use)
Let me offer you an example.

In 2019, The Infosys limited (INFY) made Rs. 39.10 in earnings per share (EPS).

It also paid Rs. 17.43 in dividends per share.

If we insert those values into the formula, this is what we get:

Dividend Coverage Ratio = 39.10/17.43  = 2.25

In other words, they were able to cover the dividend 2.25 times over.

That’s too impressive…

If that they had a bad year and their earnings dropped, they might not be ready to afford to pay the dividend using earnings only.

Ideally, the dividend coverage ratio should be nearer to 2.

This leaves companies lots of flexibility and may be 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 a similar because the Dividend Payout Ratio?

Sort of.

They both measure a similar thing, really:

How well covered a dividend is compared to earnings.
The main difference is within the formula. To calculate the payout ratio, you only need to flip the numbers around like so:

Payout Ratio = Dividend per share / Earnings per share.

Let’s use the instance of INFY again.

Payout Ratio = 17.43/ 39.10  = 0.77 = 44.57%

I personally prefer this manner of watching it, as people inherently understand percentages better.
It’s also the more widely spread way of displaying this metric, so i like to recommend you employ 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 two is that the same as a payout ratio of 50% .

Which Stocks Have the simplest Coverage?
At now I bet you’re thinking:
“OK, so I want to seek out stocks with a high dividend coverage ratio.”
And you’d be absolutely right!
This is one among the foremost important metrics – or signs – that a stock’s dividend is safe.
If an organisation encompasses a low dividend coverage, it’s putting plenty of pressure on their earnings to be ready to pay it…
On the opposite hand, if an organisation includes 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 maintain it.
Only very high-quality businesses with excellent management teams are ready to maintain it consistently.

What are these companies called?

Blue chip stocks.
Specifically, dividend growth stocks. I talk more about them during this article, where I also reveal 3 high dividend blue chip stocks.
A portfolio filled with them will make sure you keep getting paid an income which your money keeps growing.

If you’d wish to learn the method to search out and analyze blue chip stocks (dividend growth stocks) then I’ve put together a free PDF guide that shows you exactly the way to start .

It’s pretty good if I say so myself! 😆

Just let me know where to send it within the form below.