How to avoid dividend cuts from the UK's highest yielders

If you look up the FTSE 100 stocks with the biggest yields, you’ll find a couple at about 10%, which suggests an income of £100 a year from an investment of £1,000. That is about twice what you could get from cash in a best-buy savings account, albeit with the risk that money held in shares can lose value where your money in cash cannot.

It’s a no-brainer, isn’t it: just put your money in such a stock, use the dividends to buy more of the shares and the power of compounding might double your money in about seven years.

Not so fast.

A bank account may pay less but at least you are certain to get the interest promised. And your ‘principal’ – the amount you invested at the outset – is safe too. Neither of those things applies to stocks.

But, you may reasonably answer, it’s worth taking a bit of risk if the reward is a 10% yield. Indeed it may be; everything depends on how sustainable that yield is – in other words, whether the dividend payments on which it is based will continue in future.

How can you determine whether a company’s dividend payments can be relied on? Here is our seven-step checklist.

Step 1: check the ‘dividend cover’

Dividends are in theory a share of the profits that companies pay to shareholders when the money is not needed for investment in the business. But in practice a company can pay a dividend even in years when it has made a loss (the technical reason for this leeway, which involves something called ‘distributable reserves’, is too complex to go into here). It’s much better though, if we want a sustainable dividend, if the company has made a profit from which to pay the divi. Better still if the total amount paid in dividends is substantially less than the company’s profits: this means that even if the company is less profitable the next year, there is a good chance that profits will still exceed the dividend, which will make it more sustainable.

So the first step is to see how profitable a company is, and how consistent its profits have been. This information is readily available online: you can download recent annual reports from the company’s website or use one of a plethora of online sources. If we take as an example Vodafone, whose 10.3% yield, according to the London Stock Exchange’s Datastream service, is the highest in the FTSE 100, we go to its page on the Fidelity website and then select the tab marked ‘Financials’. Here we can see not only how much profit the company made in its most recent full year but the profit figure for the previous seven years too, which allows us to get a good idea of the consistency of its earnings. Look for the line entitled ‘Net income’: this is the profit after tax.

We also want to work out the ‘dividend cover’, which is the extent to which profits exceed dividends, in other words a measure of the ‘safety margin’ available before the dividend may come under threat. It is defined as the profit divided by the dividend and there are two ways to calculate it: we can divide the company’s total profit (typically a figure in the millions or billions of pounds) by the total it has paid in dividends that year, or we can make the calculation on a ‘per-share’ basis, when we divide the earnings per share (the after-tax profit attributable to each share in the company) by the dividend per share.

We will adopt the first method because, on the Fidelity web page we mentioned, we can find both the after-tax profit and the total paid in dividends. We simply divide one by the other to arrive at the dividend cover. Generally speaking, the higher this figure, the safer the dividend.

Worked examples: We’ll cover two examples – one will be Vodafone, the other DCC, an energy, healthcare and technology company that may not be as familiar as Vodafone but whose market value of £5.2bn takes it into the FTSE 100.

How does Vodafone measure up? Our web page (under ‘Income statement, Net income) shows that it made €1.1bn in post-tax profits in its most recent financial year. If we scroll down that page to the ‘Cash flow’ section and then look at the line ‘Cash dividends paid’, we find a figure of €2.4bn. So the company did not make enough in profits to cover its dividend; the actual dividend cover figure is 1.1/2.4 or 0.46. This is a bad sign but we also want to see how Vodafone’s dividend cover was in previous years, so we compare those two figures in each of the years included. For 2023 it made profits of €11.8bn and paid €2.5bn in dividends, so the payment was very comfortably covered and the cover figure was 4.7 times. Go back to 2022, though, and profits of €2.2bn compare with divis of €2.5bn for cover of 0.9 times. If we look further back, the company made a loss in 2017, 2019 and 2020, so we cannot even calculate a cover figure.

How about DCC? Our web page for DCC shows that it made £326m in post-tax profits in its most recent financial year and paid a total of £189m in dividends. The payment was therefore covered 1.7 times. We can also see that the company has been profitable every year since 2017 and that its profits have increased over that period, in a fairly steady way, from £216m in 2017 to that figure of £326m now. The total amount paid in dividends increased every year from £90m in 2017 (for cover of 2.4 times) to the current £189m. This shows consistent growth in profits and dividends.

Step 2: check the ‘cash’ dividend cover

Making profits and producing cash are not the same thing (for a fuller explanation, see this article). To be sure that a company is generating enough cash to pay its dividend, we can divide its cash flow by the dividend, just as we earlier divided the profits by the divi.

How does Vodafone measure up? On the same ‘Financials’ page we used before, we can see under the heading ‘Cash flow’ a line headed ‘Free cash flow’. This is the figure we compare with the total dividend, which is helpfully on the line below. In the most recent year Vodafone’s free cash flow was €9.7bn, compared with dividend payments of €2.4bn, so the divi was covered by cash flow four times. In the 2023 financial year, cash flow of €8.8bn covered the €2.5bn dividend 3.5 times over. Going back further we can see that Vodafone’s cash flow was much more consistent than its profits; it was always positive and always exceeded the dividend payment, often very comfortably.

What about DCC? On its Fidelity web page we can see that in the most recent financial year it made free cash flow of £492m, which is 2.6 times the dividend payment of £189m. In 2023, cash flow of £427m exceeded dividends of £178m 2.4 times. Going back to 2017, the dividend grew consistently while the cash flow suffered some fluctuations, although it always comfortably exceeded the dividend.

Step 3: Look at the dividend record

Ideally you want a steadily increasing dividend from year to year, over as long a period as possible. Here we need to look at the dividend per share figure, not the total paid in divis, because fluctuations in the number of shares in issue can cause the two figures to tell different stories. Dividends per share are available on the ‘Dividends’ tab of the Fidelity web page for the company concerned.

How does Vodafone measure up? If we go to its ‘Dividends’ tab we can see that the annual payments are presented both as a table and as a chart. The chart is easier to read and it shows that the company cut its dividend per share in 2019. While this is a troubling sign for an investor who wants a reliable yield, we also need to assess the company’s current position and intentions for the future, as we will below. Note that although our web page quotes a figure of 0.045 for the 2024 full-year dividend, and so the chart appears to show a cut, the page has not yet been updated to reflect the final dividend; Vodafone’s total divi for the year was in fact 0.09 euros, the currency in which it declares its payments to shareholders, and the figure is unchanged from the previous year.

What about DCC? On its ‘Dividends’ tab we see from the chart a very steady rise in the dividend per share from 2015 to 2023, but then an apparent fall this year. Here too, however, the page has not yet been updated to reflect the full-year payment, which came to £1.9657, a figure that does exceed the previous year’s total of £1.9021. (Note that the Fidelity website reports sterling dividends per share in pounds, not pence.)

Step 4: Look at the company’s debts

One of the oddities of the way companies operate is that it’s perfectly permissible to borrow money at the same time as they pay a dividend to shareholders. Indeed, it’s not necessarily a problem, as long as debts are not growing unsustainably. How can you tell?

One measure we can use is ‘financial leverage’, which is included in the stats on our website; go to the ‘Valuation’ tab for the company you are interested in.

How does Vodafone measure up? On its ‘Valuation’ page, the chart of financial leverage shows a slow rise between 2015 and 2022 but a fall after that. Especially at a time of falling interest rates, this should not be a cause for concern. The company also said in its annual report that it would ‘adopt a new lower target leverage range’.

What about DCC? Although its financial leverage is higher than Vodafone’s, it has seen only mild fluctuations since 2015 and in fact now stands lower than it did then.

Step 5: Look for a dividend policy and what management says about the dividend

Of course, we need to be aware of a company’s plans and hopes for its dividend. Sometimes, for example, a business may decide to change course to target greater growth and fund it in part by paying a smaller dividend. Or it could do the opposite. The best thing to do is take a look at the annual and interim reports (the chairman’s and chief executive’s statements should be enough) and keep an eye on company announcements. Our website carries recent ones on the ‘News’ tab for each stock; alternatively you can use the London Stock Exchange’s Regulatory News Service.

How does Vodafone measure up? On page 8 of its 2024 annual report it says it announced in March a new ‘capital allocation framework’, part of which is to ‘re-base’ (an irritating City euphemism for ‘cut’) the dividend by half.

This is the hidden bombshell for income investors. Wherever you look up Vodafone’s yield online, you will see that figure of 10% or so quoted. Yet no one who buys the shares today will receive a divi of £100 next year for every £1,000 invested: they will get just £50, because the dividend is to be halved. The dividends on which that 10% figure is based have already been paid to those who owned the shares at the time. The true yield if you buy now is 5% (assuming that the company pays the divi it plans in 2025). This shows how vital it is to check what a company says about its future dividend, as well as its dividend record.

Sometimes you will see a yield quoted on the basis of the expected dividend as opposed to the one already paid. The former yield is normally called ‘prospective’ and the latter ‘historic’.

What about DCC? In its 2024 annual report the company said: ‘DCC has now increased its dividend to shareholders in every one of the 30 years since the company listed, growing its dividend at a compound annual rate of 13.2%’, although there is of course no guarantee of future dividend increases.

Step 6: Look out for a yield that’s suspiciously high

The easiest way to spot a yield that may be unsustainable is to see if it’s too good to be true. The market will not allow a company that pays a reliable dividend to yield 10% if the average yield at the time is less than half that number (the FTSE 100 on average yields about 3.7% now). Investors would simply buy the shares and push the price up until the yield fell to a figure more in line with rival stocks. Vodafone’s planned halving of its divi illustrates this rule nicely. So, it’s best to be particularly careful before you invest in a share whose yield is far from the average of the market or its peers. In the current market, that could mean a yield of 5% or more, while figures of 6%, 7% or higher require even greater scrutiny.

This is not to say you should never invest in a stock that yields 10%; rather that you should take heed that the market, by making the yield so high, is expressing great scepticism about the sustainability of the dividend.

How does Vodafone measure up? The stock’s 10% historic yield puts it firmly in the ‘tread carefully’ category and, as we have seen, the dividend is about to halve.

What about DCC? DCC’s yield of 3.6% is much more in line with the market.

Step 7: Check for recent business upsets

Checking for decent dividend cover and cash cover, and seeing a long record of rising profits and dividends, are all very well but they are about the past. They will count for little if the company has just announced that it has run into trouble, perhaps with trading, financing, personnel or any other problem that can afflict a business, often with little warning.

So, it’s a good idea to check for any recent announcements from the company, such as via the Regulatory News Service mentioned above, and for news about the company in the media. The Fidelity website is also a source of company updates. To be really confident that nothing has happened that could affect the dividend in future, it would be best to check for any relevant news as far back as the most recent dividend declaration. Listed companies are obliged to make public any material developments.

How does Vodafone measure up? On the ‘News’ tab of the Vodafone page on Fidelity’s website, the most recent announcement, from 7 August, is headlined ‘Vodafone launches €500m share buyback’. Share buybacks, which are explained here, are something that companies tend to carry out when they have surplus cash, so this announcement is reassuring in the sense that it bodes well for the company’s ability to pay the divi it plans for next year, even if it is half the previous payment.

What about DCC? On our ‘News’ page for the company there is a report from 15 August of broker research that says the shares have underperformed the sector this year ‘despite in-line results and no real new news’. That suggests an absence of developments that could influence the dividend.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.