Overdistribution, an alarm signal for the UK stock market?
Liseth Galvis - 11 October 2017
The dividend cover ratio for the FTSE100 companies fell below 1 last year, and threatens to fall further when the 2017 results are in. UK quoted companies have come under increasing pressure from institutional investors to grow their dividends and, whenever possible, make additional one-off payments to shareholders. The continuation of extraordinarily low borrowing costs, an intended consequence of Quantitative Easing, invites the scenario in which corporate balance sheets are loaded with unnecessary debt, to help satisfy the income appetites of investors.
The dividend cover ratio is defined as post-tax earnings divided by dividends paid out to shareholders.
Using data provided by Capita Asset Services and The Share Centre’s Profit Watch, we can track the descent of the cover ratio since 2008 (figures 1 and 2). The UK ratio for the wider grouping of FTSE350 has been below 1 since Q1 2016 and has decreased 18 per cent year on year in Q4 2016: reported earnings have fallen by 7.6 per cent, but dividends have increased by 7.1 per cent.
A cover ratio below 1 naturally raises concerns about the sustainability of dividends, particularly in the event of a cyclical downturn in corporate earnings. The calculation for the FTSE 100 is skewed by the over-distributions of 16 companies, including the oil and gas giants, BP and Royal Dutch Shell, financials, Lloyds Banking, RSA, Capita and St James Place, property companies, Land Securities and British Land, GlaxoSmithKline, Vodafone, Imperial Brands and Marks and Spencer. However, BT and utilities, Centrica and National Grid, are also fully distributed.
The website “Dividendyields.org” enables the dividend cover ratio to be calculated for FTSE250 companies. While the aggregate ratio remains above 1, there are prominent examples of over-distribution such as Talktalk Telecom, Icap and Kier Group.
This is a worrying signal for the stock market, after a sequence of strong annual earnings growth, especially as Earnings Per Share (EPS) can itself be manipulated to give a misleading impression of corporate health. Companies are struggling to maintain profitability of Brexit. The depreciation of Sterling has also pushed up input costs for many businesses, squeezing margins.
Enron offers an iconic example of a company where reported EPS supported false beliefs about the company’s financial viability. Its EPS increased from US$1.12 to US$1.22 between 1996 and 2000, but Enron was declared bankrupt in 2001. Dividends, which must be paid in cash, provide additional reassurance that earnings are matched by cash flow generation.
The growth rate of UK business investment has decreased substantially from 9.7 per cent in Q2 2014 to 2.5 per cent in Q2 2017, suggesting that companies are reluctant to invest. The pressure to keep up dividends and refrain from investment may be limiting productivity growth in the UK. Not only may QE have contributed to an unsustainable bubble in equities, but it may also be undermining the long-run growth potential of the economy by deterring investment.
Data source: The Share Centre
Data source: The Share Centre
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