Investing with only one piece of information

Investor ratios

I would never advise making an investment with only one piece of information. I would strongly advise careful analysis, with an aim to gain a strong insight into a business and how it works. However, I thought that it may be an interesting thought exercise to try to see what would happen if we limited ourselves to one piece of information.

Dividend cover ratio

If I could invest with only one piece of company information to look at, I would look at the dividend cover ratio. Literally, this measures the company's ability to pay dividends out of the cash generated.
It is the division of the company's earnings per share divided by it's dividend per share. Put more simply, it states how much money the company pays out compared to how much it generates.

The reasoning for preferring dividend cover ratio

Why do would you invest in a company? Primarily for a return in the form of a capital gain and for dividends. The dividend cover ratio tells you several pieces of vital information. It tells you that the company pays a dividend. Furthermore, it tells you how sustainable those payments and whether those payments are likely to continue into the future.

Ideally we would want a dividend cover ratio of 2. This suggests that for every two pounds of net profit generated by the Company, it pays out one pound in dividends. This is ideal as it provides a level of comfort to suggest that the Company will be able to continue paying those dividends into the future. Furthermore you would also want to see a sustained or increasing dividend cover over the last few years.

A point of note with dividend ratio

I would emphasise here that noone should ever make an investment decision based solely on one metric. There are many other pieces of information that an investor would want before making a decision. For example you would want to know that the Company has growing revenues, assets and liabilities.

However, whilst I would never invest based on this one metric it is an interesting thought experiment. Additionally, the dividend cover ratio is a good place to start when trying to identify companies with which to invest. The dividend cover ratio provides a very good means by which to produce a shortlist of investments.

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Liquid said...

This is certainly one metric I look at when buying dividend stocks. I sometimes look at the ratio in reverse, so for example instead of the cover ratio at 2, I would say the payout ratio is 50%. I wonder how companies with good dividend cover ratios compare in performance to their index over the last 10 or 20 years.

Mr. Moneybanks said...

Hi Liquid, thanks for the comment. That would be an interesting piece of research. Get in touch if you want to look into it with me?

Dividend said...

Dividend cover is a company’s earnings ratio over the dividend paid to shareholders. It is calculated as earnings per share divided by the dividend per shows whether the company generates enough cash for dividend payout.