If youre looking for dividend yields that are both high and reliable, its tempting to focus on the FTSEs biggest dividend stocks.
Whats unusual about the current market is that the biggest dividend stock of them all Royal Dutch Shell (LSE: RDSB) is currently offering a dividend yield of 7.4%.
Shell is famous for not having cut its dividend since World War II. Chief executive Ben van Beurden is keen to maintain this record, which attracts a lot of long-term shareholders. But a yield this high is very often a sign of a dividend thats unaffordable.
Is a cut likely?
With profits recovering from the oil crash, Shell trades on a 2016 forecast P/E of 23, falling to a P/E of 12.5 for 2017. These figures look reasonable to me.
While the groups net debt of $75bn is higher than Id like to see, Shells low borrowing costs and long-term outlook should mean that debt-related problems are unlikely. However, this rising tide of debt could put pressure on dividend payments.
Shells dividend wasnt covered by earnings last year, and isnt expected to be covered this year. If earnings dont recover next year, I believe the chances of a cut could rise sharply.
Luckily, Shells earnings are expected to rise to $2.05 per share in 2017. This would give dividend cover of 1.1 times. Free cash flow should also improve, assuming oil manages to climb above $50. In this scenario, I think a dividend cut is unlikely.
However, theres a risk that oil will stay low. Shell may reach a point where borrowing money to pay the dividend no longer makes sense. If we use this years forecast earnings of $1.11 per share as a baseline, I estimate that in a worst-case scenario, the dividend could be cut by 45% to $1 per share.
Doing this would reduce Shells dividend yield to 4%. I dont think such a big cut is likely, but the reality is that a yield of 4% would still be attractive. Indeed, some investors would argue that it would be more attractive because it would be affordable!
A better alternative?
While I rate Shell as an income buy, the risk of a dividend cut means that for me, its not a best buy.
If youre look for a high dividend yield that can keep pace with inflation, then utility group SSE (LSE: SSE) might be a better alternative. SSE shares offer a 6% yield and have risen by 24% over the last 10years, compared to just 13% for the FTSE 100.
SSEs policy is to increase its dividend in line with RPI inflation. This policy is expected to be maintained until at least the 2018/19 financial year.
Last years dividend cover of 1.34 times suggests to me that SSEs payout should remain affordable, especially as the group believes theres now increased clarity on future energy policy.
City analysts are also taking a more positive view of this stock. Forecast earnings for the current year have risen since March, recouping the losses seen last year and putting the shares on a forecast P/E of 13.
Id be happy to add to my own holding at current levels, and rate the shares as an income buy.
Roland Head owns shares of Royal Dutch Shell and SSE. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
