The tax-free nature of an ISA means that it’s 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, it’s important not to chase yield — don’t buy a stock just because it has a high dividend yield.  Â
For example, Vodafone’s (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. Â
Numbers don’t 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.Â
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.Â
Still, in many respects these numbers do not give the whole picture. Vodafone’s per 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 Vodafone’s dividend payout is to look at the company’s cash flows.
Using this method of analysis, Vodafone’s payout looks to be well covered by cash generated from operations. For the six months to September, Vodafone’s dividend payout cost the company £2bn, which was easily covered by the £3.7bn in cash generated from operations.Â
Nevertheless, even using Vodafone’s cash flow figures there is reason to believe that the company will be forced to cut its payout.
Firstly, these numbers don’t account for bolt-on acquisitions and capital spending. Vodafone’s capital spending totalled £5.3bn in the six months to September and most of this was funded with debt.
Secondly, the figures don’t take into account the cost of mobile spectrum auctions that Vodafone has to take part in. It’s estimated that these auctions cost the company around £1bn a year, although many forecasts don’t account for this factor.
Thirdly, Vodafone’s 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 Vodafone’s net debt to equity ratio stood at 29%, up from 16% as reported only six months before.Â