{"id":2101,"date":"2018-02-12T20:22:53","date_gmt":"2018-02-12T20:22:53","guid":{"rendered":"http:\/\/frugalstudent.co.uk\/?p=2101"},"modified":"2018-02-13T19:08:18","modified_gmt":"2018-02-13T19:08:18","slug":"calculating-dividend-cover-flawed-i-use-instead","status":"publish","type":"post","link":"https:\/\/frugalstudent.co.uk\/index.php\/2018\/02\/12\/calculating-dividend-cover-flawed-i-use-instead\/","title":{"rendered":"Why calculating Dividend Cover is flawed\u2026. What I use instead"},"content":{"rendered":"

Some of my worst investments were made back in 2014\/15.<\/span><\/p>\n

That\u2019s the year I really got stuck into investing.<\/span><\/p>\n

I blindly piled into stocks I would never buy at such valuations today.<\/span><\/p>\n

I look at them in my portfolio today and cringe.<\/span><\/p>\n

Glaxo Smith Kline, Whitbread\u2026 It just hurts.<\/span><\/p>\n

Now, while Whitbread may be a decent buy at these prices, I\u2019m down 15% and t<\/span>o be completely honest, I wouldn\u2019t be buying at these prices regardless.<\/span><\/p>\n

Luckily, one core calculation and one change to my investment style\u00a0has stopped me from getting stung further.<\/span><\/p>\n

In this weeks article, I\u2019m going to share that calculation with you and that change with you.<\/span><\/p>\n

Earnings Per Share<\/strong><\/span><\/p>\n

Now, many of you would have already heard about EPS (Earnings Per Share). That\u2019s simply a company\u2019s net profit divided by the number of shares outstanding. <\/span><\/p>\n

This is a key <\/b>measure often touted by company management, brokers, and analysts.<\/span><\/p>\n

Naturally, when I first got into investing this was also the key <\/b>metric I focused in on – a<\/span>fter all, that\u2019s what the pros and other dividend bloggers were doing.<\/span><\/p>\n

Little did I know at this point that this focus would lead disastrous\u00a0<\/span>investments.<\/span><\/p>\n

Now, there\u2019s nothing wrong with focusing in on a company\u2019s earnings per share but it\u2019s the use of EPS in order to determine a dividend’s safety that gets me.<\/span><\/p>\n

Ever heard of\u00a0dividend cover?<\/b><\/span><\/p>\n

My focus on dividend cover actually lead to me investing into companies with pressed dividends!\u00a0<\/span><\/p>\n

Dividend Cover<\/strong><\/span><\/p>\n

Dividend Cover = Dividend Per Share\/Earnings Per Share<\/span><\/strong><\/p>\n

For example, Company X has earnings of \u00a31.00 per share and pays a \u00a30.50p dividend then the above calculation results in a dividend cover of two.<\/span><\/p>\n

1\/0.5 = 2<\/span><\/p>\n

Now, on the face of it, this makes the dividend look well covered.<\/span><\/p>\n

After all, earnings per share could theoretically half and the dividend could still be paid.<\/span><\/p>\n

One would assume that the dividend safe <\/b>right?<\/span><\/p>\n

Wrong, and I\u2019m going to tell you why.<\/span><\/p>\n

The calculation for Earnings Per Share is: Total earnings\/Outstanding Shares.<\/span><\/p>\n

So far so good.<\/span><\/strong><\/p>\n

Let\u2019s assume Company X has earnings of \u00a3100 and 100 shares outstanding (let\u2019s keep things simple).<\/span><\/p>\n

100\/100 = \u00a31 Earnings Per Share.<\/span><\/p>\n

But, what earnings per share doesn\u2019t take into account is Capital Expenditure – the money a business spends in order to maintain, upgrade and purchase new physical assets.<\/span><\/p>\n

If Company X spends \u00a340 on maintenance and a further \u00a330 on purchasing a new asset the dividend is suddenly left uncovered by cash generated through by the company’s operation.<\/span><\/p>\n

We said above that the company paid a 50p dividend per share.<\/span><\/p>\n

0.50 x 100 (the number of shares) = \u00a350 total dividend paid.<\/span><\/p>\n

Add on the \u00a370 spend in Capital Expenditure and we can see that the company actually forked out \u00a3120 while it only generated \u00a3100 in earnings.<\/span><\/p>\n

Where did that extra \u00a320 come from I hear you ask?<\/span><\/p>\n

Debt, new share issues or asset sales, all of which are reflected in a company’s cash flow statement and can be damaging over the long term.<\/span><\/p>\n

Debt and share issues are reflected under the\u00a0financing <\/strong>tab of a company’s cashflow statement with asset sales\u00a0 under\u00a0other investing and cashflow items<\/strong>.<\/p>\n

So should you worry if a company has to rely on asset sales, debt or share issues to pay a dividend?<\/p>\n

Not necessarily but it means you need to dig deeper into a company’s annual report in order to find out\u00a0exactly\u00a0<\/strong>what’s going on in order to determine if adding more debt is sustainable and whether asset sales damage the overall business.<\/p>\n

As for share issues – this is almost\u00a0always<\/strong> bad news for investors!<\/p>\n

 <\/p>\n

Let\u2019s take a real-world example to see how this all works out<\/b><\/span><\/p>\n

Here\u2019s Whitbread’s Cashflow statement.<\/b><\/span><\/p>\n

\"\"<\/p>\n

We\u2019ll start in 2013.<\/span><\/p>\n

I always begin by working out a company\u2019s Free cash flow excluding other investing and cashflow items.<\/span><\/p>\n

This is because I want to see whether a company generates enough cash from its core operations to fund growth and pay the dividend, without the need for any cash generation from Property Plant and Equipment activity such as asset sales.<\/p>\n

That\u2019s Total Cash From Operations – Capital Expenditures (Capex).<\/span><\/p>\n

2013 = \u00a363m<\/span><\/p>\n

Great, that\u2019s \u00a363m worth of SURPLUS cash that Whitbread has after all costs including Capex.<\/span><\/p>\n

BUT, we can see that they paid out a \u00a378m dividend meaning that they had to generate \u00a315m.<\/span><\/p>\n

As it happens, in 2013 WTB gained \u00a350m from an asset sale meaning the dividend is covered (reflected in 2013’s cashflow statement)<\/p>\n

\"\"<\/p>\n

Using this formula, we can truly work out whether a dividend is covered.<\/strong><\/p>\n

Do the maths for 2015 and you’ll see that the dividend is grossly un-covered thanks to huge Capex.<\/p>\n

Jumping forward to 2017 we can see that the dividend has become even more pressured.<\/span><\/p>\n

Free cash flow = 626 – 610 = \u00a316m <\/span><\/p>\n

WOW! The dividend paid in 2017 was a whopping \u00a3167m.<\/span><\/p>\n

Where did the additional \u00a3151m come from!?!<\/span><\/p>\n

Well, if we consider the other investing activities you’ll notice that Whitbread made \u00a3200m.<\/p>\n

Fair enough right? That covers the dividend.<\/p>\n

Well, if we dig into the annual report, we can see that much of this money (186.2m) came from the sale and leaseback of hotels &\u00a0restaurants.<\/p>\n

\"\"<\/p>\n

Thus we have uncovered a red flag!<\/p>\n

By leasing back a hotel the company has added an overhead for a one-off payment.<\/p>\n

This seems concerning\u00a0as this sale was required due to the weight of the dividend and the huge levels of CapEx needed in the hotel and restaurant sector.<\/p>\n

It’s also worth looking at the company’s liabilities in light of its capital-intensive nature.<\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2017\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2016\u00a0 \u00a0 \u00a0 \u00a0 \u00a02015\u00a0 \u00a0 \u00a0 \u00a0 \u00a02014\u00a0 \u00a0 \u00a0 \u00a0 \u00a02013<\/strong><\/p>\n

\"\"<\/p>\n

As we can see, total liabilities have rocketed from \u00a31,640m in 2013 to \u00a32,161m in 2017 with total debt nearly doubling.<\/span><\/p>\n

This isn\u2019t actually that bad considering how cheap debt is at present and considering that the company has also grown its assets substantially.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2017\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2016\u00a0 \u00a0 \u00a0 \u00a0 \u00a02015\u00a0 \u00a0 \u00a0 \u00a0 \u00a02014\u00a0 \u00a0 \u00a0 \u00a0 \u00a02013<\/strong><\/p>\n

\"\"<\/p>\n

We can see that the liability to asset ratio has remained broadly stable (Liabilities\/assets)<\/span><\/p>\n

2013 = 1640\/3175 x 100 = 52%<\/span><\/p>\n

2017 = 2161\/4689 x 100 = 46%<\/span><\/p>\n

But.<\/span><\/p>\n

Here\u2019s the piece of the balance sheet that makes me cry as an investor.<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2017\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2016\u00a0 \u00a0 \u00a0 \u00a0 \u00a02015\u00a0 \u00a0 \u00a0 \u00a0 \u00a02014\u00a0 \u00a0 \u00a0 \u00a0 \u00a02013<\/strong><\/p>\n

\"\"<\/p>\n

Whitbread has issued a further 4m shares since 2013, diluting shareholder equity.<\/span><\/p>\n

Each time a company issues shares, your stake in the company is decreased.<\/p>\n

Someone who owns 1\/100 shares in a company owns 1%.<\/p>\n

If the company issues another 10 shares, you now own just 0.9%<\/p>\n

Whilst 4m shares over 5 years is far from terrible, just 2.2% of total shares outstanding, when we compare this to a company with low Capex and plenty of cash to spare the importance of free cash becomes pronounced.<\/p>\n

Here are the number of Next Plc shares outstanding;<\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a02017\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 2016\u00a0 \u00a0 \u00a0 \u00a0 \u00a02015\u00a0 \u00a0 \u00a0 \u00a0 \u00a02014\u00a0 \u00a0 \u00a0 \u00a0 \u00a02013<\/strong><\/p>\n

\"\"<\/p>\n

So, how do I REALLY know if a stock\u2019s dividend is under pressure?<\/b><\/span><\/p>\n

Simple.<\/span><\/p>\n

These are the EXACT steps you need to do.<\/span><\/p>\n