Dividend cover is a financial metric that divides the Earnings Per Share of a firm by the dividend per share paid out to shareholders.
Dividend Cover Explained
It measures the risk investors face of not receiving dividends, as it describes the number of times a company can afford to pay the dividend out of current earnings.
As a general rule, any ratio below 2 might be considered a cause for concern that the dividend is vulnerable to being lowered or eliminated altogether.
A firm’s ability to pay out dividends is crucial for investors as they constitute a large proportion of the total return generated over time.
A company can either re-invest the income generated in the course of its business or direct the money to shareholders.
Trading Using Dividend Cover
The Dividend Cover number tells investors how much of the returns are shared with shareholders and to what extent those dividends are secure.
A low number could be due to a decline in earnings power OR an overly generous dividend pay-out policy, but either way, it may signal that the current dividend level is unsustainable and may be cut or even terminated.
Investors looking for income from shares will pay close attention to this ratio as it may indicate how well the firm is doing and whether the investor can reasonably expect dividend growth to be maintained.
Dividend coverage can vary between firms, making cross-industry comparisons difficult.
A stable, mature and consistently profitable company (e.g. a utility company) may well be able to pay a higher dividend and sustain lower overall coverage as they can be surer of the repeatability of their earnings, whilst a small start-up firm may not be able to pay any dividends, at least at first.
Should the business succeed, however, one could reasonably expect higher and faster growing dividends in the longer term, unlike the utility firm for example, who are already paying out as much as is reasonable, whilst having no way to grow the business sufficiently to allow for higher and faster dividend growth.