A corporation pays dividends to its shareholders as a way to distribute a portion of the company's profits to the owners -- the shareholders. Stock dividends are not guaranteed, and a corporation's board of directors must vote before each dividend declaration on whether to pay a dividend and for how much. The dividend cover calculation allows investors to predict whether a company can keep paying dividends at the current level.
The dividend cover amount of a stock's dividend shows how much of the corporation's net profit is paid out as dividends. Typically, a company must be earning enough in profits to "cover" the dividend. If there is not enough earnings, the corporation will probably reduce or eliminate the dividend payout. Stock investors who count on their dividends to fund portfolio growth or their income want to see a high level of dividend cover.
Dividend cover is calculated by dividing the period's earnings per share by the dividend payout amount. Many corporations pay dividends quarterly when they make their SEC required earnings reports. The earnings report will give the numbers necessary to calculate the dividend coverage. For example, in the third quarter of 2010, IBM reported net earnings per share of $2.82. The quarterly dividend from IBM in 2010 was $0.65 per share. Dividing 2.82 by 0.65 gives dividend coverage of 4.3 times.
A dividend cover ratio of less than one indicates the company is not earning enough profits to cover the current level of dividend payment. A dividend cover of two means that profits are twice the level of the dividend payout. Companies that are growing earnings and putting most of the earnings back into the company may have a high dividend cover due to a low dividend amount.
For income-oriented investors, the best combination is a high current dividend plus a high dividend cover. The high dividend cover indicates the company has enough profits to increase the dividend in the future. For companies whose profits fluctuate from quarter to quarter, an investor should calculate the dividend cover using the annual earnings per share and and dividend payout. Investors can compare different companies by looking at both the dividend yield and dividend cover. For example, 3M Company, stock symbol MMM, has a history of steadily increasing dividends. In 2010, 3M had a dividend yield of 2.50 percent and dividend cover of 2.6 times.
Using dividend cover is not the appropriate evaluation tool for several types of high dividend yield stocks. Real estate investment trusts (REITs) and master limited partnerships (MLPs) usually have high levels of depreciation that reduce the net income per share and mask the true cash flow of the company. These types of stock should be evaluated using the measurement of cash flow from operations or free cash flow.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.