Dividend cover

Dividend cover measures the relationship among earnings per share and net dividends per share. The higher the altitude of dividends for any given level of EPS the lower will be the level of profit retained and re-invested within the business. This is able to have an effect on the balance of returns available to an equity investor.

The returns from spending in shares may take the form of either income that is dividends which are paid twice yearly or capital gain/loss which is earned when the shares are sold. A few investors may prefer one type of return to the other often for tax reasons.

Dividend cover is measured as follow Earnings per share (net)/dividend per share (net). Using the instance of Zellus plc the net EPS is 18 cents. The gross dividend is nine cents and thus if tax is payable at 20% then the net dividend equals 7.2 cents. Using the formula dividend cover equivalents 18/7.2 which provides a dividend cover of 2.5.

In other prose Zellus' earnings are sufficient for the company to be able to pay out dividends at a rate 2.5 times their current stage. By contrast Buntam has an EPS of eight cents and a net dividend per share of 6.4 cents giving a dividend cover of just 1.25.

Investors need to understand the relationship between dividend cover and investment returns. As a universal rule the greater the level of retention and dividend cover the greater the likelihood that a share will yield capital gain rather than income. From the instance given above it would thus appear for Buntam plc paying out almost all their earnings as dividends there is limited scope for capital growth in the share price. By contrast Zellus has a comparatively high dividend cover and so the reinvestment of profits should generate capital gains. As with every investor ratios dividend cover has to be interpreted with caution and alongside a number of other measures.