Step 1 – Dividends and dividend cover

“Each company should have a long record of continuous dividend payments.”

Benjamin Graham, The Intelligent Investor

Dividends make up the backbone of my investment strategy, so I like to start the process of analysing a company with a few simple checks on its dividend history and the earnings upon which those dividends depend.

To make sure we’re on the same page, here’s a definition:

There are several reasons why dividends are central to my approach. The most important reasons are:

1) Efficient capital allocation

A company should only retain cash generated from operations if that cash can be used to produce an attractive return. The main uses of retained cash are:

1. Maintaining the existing business
2. Growing the business (e.g. buying new factories, stores or equipment)
3. Paying down debt
4. Buying back shares

When those options are exhausted, cash should be returned to shareholders as a dividend.

With companies that don’t pay a dividend there is, in my opinion, a greater risk that cash retained within the business will be used to expand the CEO’s empire (and pay packet) rather than maximise returns for shareholders.

2) Commitment and accountability

Companies with progressive dividend policies have made a promise to investors that they will maintain or grow the dividend each year.

This provides a public and very concrete goal for management to achieve. Of course this promise can be broken, but on average dividend-paying companies have historically performed better than non-dividend payers.

3) A helpful yardstick

A progressive dividend gives investors a gauge for the long-term progress of a company. While earnings – and to a lesser extent revenues – bounce around from year to year, a progressive dividend can give a good indication of the underlying growth rate of a company.

4) A cash income

Perhaps the most obvious benefit of dividends is that they are a form of cash income. For those investors who are after an income, either today or in the future, dividends are an excellent way to receive that income without having to sell any shares.

They also provide an always-positive return which is independent of a company’s share price. This can help reduce the volatility of your portfolio.

Look for a long record of continuous dividend payments

Benjamin Graham, the father of value investing, said that “Each company should have a long record of continuous dividend payments.” The logic behind this rule is simple: If investors want to buy companies that are likely to pay a consistent dividend in the future, the best place to find such companies is among those that have paid a consistent dividend in the past.

This leads to the first of many rules of thumb that make up the backbone of my investment strategy.

I don’t mind the odd missing interim or final dividend, as long as some sort of dividend was paid every year. If no dividend was paid in one or more years then the company goes straight into my metaphorical waste paper bin.

It is important to remember that a consistent dividend record is not a magic bullet. Dividends are paid at the discretion of the company’s management, so no matter how good a company’s track record, you can never be sure that the dividend won’t be cut or suspended at some point in the future.

The banking crisis of 2007-2009 was a good example of this. A whole group of companies that were thought to be safe – i.e. the big banks – turned out to be anything but safe. Most of these supposedly safe banks suspended their dividends during the crisis, and in some cases the dividend remained suspended for several years.

To put it bluntly, dividend cuts are a fact of life. If you invest for long enough in dividend-paying companies then be in no doubt that you will see a dividend cut in your portfolio at some point. However, this doesn’t mean we have to blindly accept the inevitability of dividend cuts.

It is possible to reduce the likelihood of seeing dividend cuts in your portfolio by analysing companies in detail, taking into account a range of factors such as their profitability, debt level and growth rate. As an additional line of defence, your portfolio should be widely diversified across many different companies operating in many different industries and countries. This will reduce the impact of the occasional dividend cut when it does occurs.

For now though, let’s focus on finding companies with consistent track records of profits and dividends.

Getting your hands on ten years of financial data

There are various ways to get hold of a company’s financial results for the past ten years. The obvious place to look would be the company’s annual reports, but that approach is very time consuming and any per share data, such as dividends per share, will not have been adjusted for share splits or share consolidations.

Share splits and consolidations change the number of shares a company has and the price of each share, but they don’t affect the value of each shareholder’s holdings. However, they do affect per share figures such as dividends and earnings per share, which means that per share figures from older annual and interim results have to be adjusted to take account of the change.

You could correct for splits and consolidations by hand, but my preferred approach is to get ten years of data from a data provider such as Morningstar or SharePad, at least initially, and to supplement that with the company’s official results documents as necessary.

I’ll assume you now have access to all the required financial data, so let’s analyse the dividend record of one of my investments from the last few years.

Consistent dividends from Ted Baker (TED)

Ted Baker is a FTSE 250 clothing retailer listed in the defensive Personal Goods sector. It is known for its quirky British-themed style and has more than 500 stores across the globe. It sells through three main channels: retail (stores and online), licences (product and geographical) and wholesale (e.g. through third party department stores). Ted Baker had the following dividend record for the ten years to 2019 (shown in Table 1.1).

Year	Dividends per share (p)
2010	11.90
2011	20.60
2012	23.40
2013	26.60
2014	33.70
2015	40.30
2016	47.80
2017	53.60
2018	60.10
2019	58.60

Table 1.1: Ted Baker’s dividend record through ten years to 2019

Looking for dividend payments in every one of the last ten years is a pretty simple test. Either a company made a dividend payment in every year or it didn’t. In Ted Baker’s case it did, so at this stage of the analysis Ted would still be a viable investment candidate.

Looking for earnings which regularly cover the dividend

Of course, dividends don’t appear out of thin air. A company must produce profits before it can pay dividends, and those profits will in turn depend on revenues.

To avoid any confusion, here are some more definitions:

For many years I focused on adjusted EPS in an attempt to get a better view of a company’s core performance. However, experience has taught me that adjusted EPS can sometimes paint an overly rosy picture of a company’s past.

This happens when a significant amount of expenses are repeatedly classified as one-offs by management, even when those expenses seem to recur year after year. Sometimes it can even look as if management are trying to make their results look better than they actually are.

To avoid this problem I now focus on basic earnings per share, which always deducts all expenses. This gives me a better picture of how the overall company is performing, warts and all.

The first thing I look for in a company’s earnings is that they consistently cover the dividend, which just means EPS was greater than DPS. I do this by calculating the dividend cover ratio for each of the last ten years and then count how often dividend cover was greater than one.

I’m looking for a consistently covered dividend, so my rule of thumb for dividend cover is:

Calculating dividend cover

The calculation for dividend cover is relatively simple:

dividend cover = EPS / DPS

Let’s see how dividend cover can be applied to another of my holdings from the last few years.

Consistent dividend cover at Burberry (BRBY)

Burberry is a FTSE 100 luxury fashion retailer. Like Ted Baker, it’s listed in the defensive Personal Goods sector. Also like Ted Baker, Burberry sells through three channels: retail (over 400 stores globally, plus department store concessions, discount outlets and e-commerce), wholesale (e.g. department stores and other multi-brand retailers) and brand licensing (but only 1% of revenues).

Burberry has paid a dividend in every one of the last ten years, so it passes my first rule of thumb.

To check the consistency of its dividend cover we’ll need its earnings and dividends per share for the last ten years, which you can see in Table 1.2.

Year	EPS (p)	DPS (p)	Dividend cover
2009	-1.4	12	-0.12
2010	34.4	14	2.46
2011	48.3	20	2.41
2012	59.3	25	2.37
2013	57.0	29	1.97
2014	72.1	32	2.25
2015	75.1	35.2	2.13
2016	69.4	37	1.88
2017	64.9	38.9	1.67
2018	68.4	41.3	1.66

Table 1.2: Burberry’s dividend cover, 2009-2018

Burberry’s earnings record gets off to a bad start with a loss in 2009. However, I’m not put off by the occasional loss and in this case it’s understandable as 2009 was the middle of the global financial crisis. What’s more important is that Burberry continued to pay a dividend, despite this loss.

As for dividend cover, Burberry’s dividend was covered every year except 2009, which means its dividend cover score is nine out of ten. Nine is obviously more than my minimum requirement of five, so Burberry easily meets my standards for dividend cover.

Obviously this is just the first step and there’s a lot more to do before a company can be deemed investable or not, so in the next article in this series I’ll go over how I measure a company’s growth, as growth is of course a key component of long-term returns.

For now though, here’s a quick reminder of my rules of thumb for dividends and dividend cover: