Some stock market investors choose stocks for the dividend payments. Companies can choose to pay a portion of profits out to investors in the form of dividends. Many stocks pay regular dividends, which investors count on as part of their investment returns. The dividend cover ratio is an indicator of the safety of the current dividend rate of a particular stock.
Investors are often first attracted to a stock by the dividend yield. The yield is calculated by dividing the annual dividend amount by the current stock price. As an example, in May 2011, GE was paying a quarterly dividend of 15 cents per share and the stock was priced at $20. Dividing the 60 cent annual dividend into $20 gives a yield for GE of 3.0 percent. It is important to remember that stock dividends are not guaranteed and the company can elect to change or eliminate the dividend payments.
Dividend Cover Ratio
The dividend cover ratio is calculated by dividing the stock's annual earnings per share by the annual dividend. In 2010, GE earned $1.15 per share. Dividing $1.15 by the 60 cent dividend gives GE a dividend cover ratio of 1.92. This means GE had enough earnings to cover the annual dividend 1.92 times. The higher the dividend ratio, the more protection shareholders have that the dividend will continue to be paid at the current rate or possibly be increased. Investors concerned about the safety of the dividend payout look for a dividend cover ratio of 2.0 or higher.
Dividend Payout Ratio
The dividend payout ratio is another metric used to judge the coverage of a dividend payment. The payout ratio is the inverse of the dividend cover ratio and is calculated by dividing the dividend rate by the earnings per share. In the GE example, the payout ratio would be 60 cents divided by $1.15, or 52.2 percent. An investor given a payout ratio can calculate the dividend cover ratio by dividing 1 by the payout ratio.
Stocks with high dividend yields will usually have a low dividend cover ratio, possibly even less than 1.0. Yield is determined by both the dividend rate and the stock price. The market will drive down the price of a stock with a low cover ratio, increasing the yield. The danger from high-yield stocks is the company will reduce the dividend if earnings decline. A dividend cut will result in a lower stock price, hurting investors two ways, a lower dividend and lower share price.
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.