Are dividends sustainable?

Equity investors expect returns in the form of dividends and capital appreciation. We like companies that have stable or increasing dividends and perhaps look down upon companies that cut dividends which often leads to a fall in their share price.

How can investors determine the capacity of the company to continue to grow dividends?

There are two widely used ratios to determine the dividend safety.

Dividend coverage ratio

This is the net income of the company divided by dividends. A higher than average ratio for the sector is a positive sign for sustainability of dividends. A lower than average ratio may lead to a cut in dividends.

Free Cash Flow to Equity (FCFE) coverage ratio

FCFE is the cash available for distribution to shareholders. This cash could be used for dividends and/or share repurchases. A share repurchase or buyback is an alternative to cash dividend. The advantage with share repurchases is that they are not a long term commitment and could be done occassionally as a supplement to the dividend.

FCFE coverage ratio is obtained by dividing FCFE by the sum of dividends and share repurchases. FCFE coverage ratio significantly less than one is not sustainable.