Some dividends have staying power. Companies delivering enduring dividends tend to back their often-risingpayouts with robust business and financial achievement.
Fragile dividends, meanwhile, result fromweaker operational and financial characteristics. Those are the dividends to avoid. However, fragile dividends often tempt us because of high dividend yields.
How to tell the difference
Under the spotlight today, two FTSE 100 firms: international bankHSBC Holdings (LSE: HSBA) and mobile phone service providerVodafone Group (LSE: VOD).
These firms operate in different sectors, but they both have a high dividend yield. At arecent share price of 507p HSBC Holdings forward yield for 2016 is around 6.7%. At 223p, Vodafones yield for the year to March 2017 is 5.1%.
Lets run some tests to gauge business and financial quality, and score performance in each test out of a maximum five.
1. Dividend record
Both firms enjoy a decent record of ordinary dividends:
| Ordinary dividends | 2011 | 2012 | 2013 | 2014 | 2015 |
|---|---|---|---|---|---|
| HSBC Holdings (cents) | 41 | 45 | 49 | 50 | 51 (e) |
| Vodafone (pence) | 8.9 | 9.52 | 10.19 | 11 | 11.22 |
Over four years HSBC Holdings dividend rose24%. Vodafones increased by 26%.
For their dividend records, Im scoring both firms 4/5.
2. Dividend cover
HSBC Holdings expects its 2016 adjusted earnings to cover its dividend around 1.5 times. Vodafones earnings look set to fall short of covering the forward dividend payout by around 50%.
However, cash pays dividends, so its worth digging deeper into how well, or poorly, both companies cover their dividend payouts with free cash flow, too. Last year, for example, Vodafones declared free cash flow failed to cover its dividend payments.
So , on dividend cover from earnings, Im scoring HSBC Holdings 3/5 and Vodafone 0/5.
3. Cash flow
Dividend cover from earnings means little if cash flow doesnt support profits.
Here are the firms recent records on cash flow compared to profits:
| 2010 | 2011 | 2012 | 2013 | 2014 | |
|---|---|---|---|---|---|
| HSBC Holdings | |||||
| Operating profit ($m) | 16,520 | 18,608 | 17,092 | 20,240 | 16,148 |
| Net cash from operations ($m) | 55,742 | 79,762 | (9,156) | 44,977 | (21,372) |
| Vodafone | |||||
| Operating profit (m) | 537 | 6,224 | (2,777) | (4,191) | 2,030 |
| Net cash from operations (m) | 11,995 | 12,755 | 8,824 | 6,227 | 9,715 |
HSBC Holdings ability to generate cash from its operations fluctuates. However, cash flow in banking business is a less useful indicator of business health than it is at other types of business. Banks cash flows tend to be noisy, as we see here. Accounting quirks such as how the banks classify their loans and investments, for example can bolster or lower a cash-flow number artificially.
Vodafones cash performance is much steadier and the amounts of cash realised support declared profits well.
Im scoring HSBC Holdings a benefit-of-the-doubt 3/5 and Vodafone 5/5.
4. Gross debt
Interest payments on borrowed money compete with dividend payments for incoming cash flow. Thats why big debts are undesirable in dividend-led investments.
Most banks carry big external debts and HSBC Holdings balance sheet entry for debt securities alone was almost six times the level of its operating profit in 2014. Vodafones borrowings run at around four times the level of cash generated annually from operations.
For their debt positions, both firms get 2/5.
5. Degree of cyclicality
HSBC Holdings share price moved from around 700p at the beginning of 2011 to 507p or so today, handing investors a 28% capital loss over the period, which is likely to have taken away any gains from dividend income.
Vodafone moved from around 170p at the start of 2011 to around 223p today, providing investors with a 31% capital gain.
HSBC Holdings share-price volatility results from cyclical effects, as we might expect with a bank.
Im scoring HSBC Holdings a generous 2/5 and Vodafone 3/5 for itscyclicality.
Putting it all together
Here are the final scores for these firms:
| HSBC | Vodafone | |
| Dividend record | 4 | 4 |
| Dividend cover | 3 | 0 |
| Cash flow | 3 | 5 |
| Debt | 2 | 2 |
| Degree of cyclicality | 2 | 3 |
| Total score out of 25 | 14 | 14 |
Neither firm is perfect by these measures, which makes me cautious about selecting them as dividend-led investments.
However, if you are searching for attractive dividends, you may wish to consider a company uncovered by one of The Motley Fool’s top investors. He believes the best days for the business featured in this free report still lie ahead.
Overall, turnover has been growing at around 10% a year for this business, with profit growth not far behind. The firm has a decent record of rising dividends that looks set to continue, given its clearly identified path to growth. If the dividend keeps rising, share-price appreciation could follow.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
