The tax-free nature of an ISA means that its perfect for income investors, but you need to be careful which dividend stocks you choose for your ISA wrapper.
Indeed, when picking income stocks for your ISA, its important not to chase yielddont buy a stock just because it has a high dividend yield.
For example, Vodafones(LSE: VOD) dividend yield of 5% may be one of the best around. However, analysts are not convinced that the company will be able to sustain its dividend payout indefinitely.
Numbers dont add up
At first glance it looks as if the analysts are correct. For the year ending 31 March 2015, City figures suggest that Vodafone will have paid out 11.5p per share in dividends for the year. Although over the same period, the company is only expected to earn 6.4p per share.
Furthermore, during 2016 the company is expected to pay a per share dividend of 11.8p, despite the fact that the company is only projected to earn 6.4p per share.
Still, in many respects these numbers do not give the whole picture. Vodafonesper share earnings are affected by non-cash charges like depreciation, and as the company is a capital-intensive business, these charges tend to skew results.
Cash flow issues
A better way to assess the sustainability of Vodafones dividend payout is to look at the companys cash flows.
Using this method of analysis, Vodafones payout looks to be well covered by cash generated from operations. For the six months to September, Vodafones dividend payout cost the company 2bn, which was easily covered by the 3.7bn in cash generated from operations.
Nevertheless, even using Vodafones cash flow figures there is reason to believe that the company will be forced to cut its payout.
Firstly, these numbers dont account for bolt-on acquisitions and capital spending. Vodafones capital spending totalled 5.3bn in the six months to September and most of this was funded with debt.
Secondly, the figures dont take into account the cost of mobile spectrum auctions that Vodafone has to take part in. Its estimated that these auctions cost the company around 1bn a year, although many forecasts dont account for this factor.
Thirdly, Vodafones debt is rising rapidly and at some point in the future when interest rates start to rise the company will have to think about reducing spending to pay down debt. According to the figures released by the company for the six months to September Vodafones net debt to equity ratio stood at 29%, up from 16% as reported only six months before.
Numbers point to a cut
So all in all, the figures suggest that Vodafone could be forced to reduce its dividend payout in the future, to reduce debt and fund capital spending. And on this basis, the company is a poor choice for your ISA.
That being said, before you make any trading decisionI strongly recommend that you do some additional research of your own — you may come to a different conclusion.
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