Who doesn't love a solid dividend stock?
The concept alone -- getting paid a quarterly stipend because you're a passive owner of a company -- is hard to resist. Dividend stocks are a cornerstone of many retiree portfolios, as the regular income can provide a nice supplement to Social Security payments and fixed-income investments.
But what if, heaven forbid, the dividend gets cut one day? In that case, watch out! The stock will almost assuredly tank on you.
Not only do dividend cuts mean less passive income for investors, they often indicate the underlying business itself is in major trouble. Wall Street considers the dividend sacred: sacrifice the dividend and you've sacrificed investor trust.
So, given the systemic importance of these payments, how can you tell when a dividend is in danger of getting cut? Thankfully, there are a few telltale warning signs for investors to keep in mind.
Beware of high (or increasing) payout ratios. Divide a stock's dividend payment by its earnings per share and boom, you've got the payout ratio.
High payout ratios can indicate an unsustainable dividend. After all, earnings have a tendency to dip every now and then, so you want to make sure you have some cushion room to pay the dividend if and when that day comes.
Chris Kim, chief investment officer at Tompkins Financial Advisors in New York, says that a payout ratio between 50 and 60 percent is a "warning sign."
"However, like all ratios, the payout ratio is industry-specific. Very stable industries, such as utilities, have high payout ratios," he says. Companies with greater growth potential tend to have lower payout ratios since they need to reinvest more of their earnings.
Jim Wright, a Covestor portfolio manager and chief investment officer of Harvest Financial Partners in Paoli, Pennsylvania, says a ratio greater than 100 percent is a red flag.
And, he says, the trajectory of the payout ratio is just as important. If the ratio is rising, a greater percentage of earnings are being diverted away from reinvestment opportunities, which is never good.
Still, that's tolerable in the short term. "But, if the payout ratio continues to grow, then a dividend cut is a real risk," Wright says.
Ultimately, free cash flow needs to finance the dividend, not earnings. Looking at a company's earnings statement gives you a good general idea of how sustainable the dividend is. But dividends are paid in cold, hard cash.
And while companies are welcome to use their savings or borrowed capital for dividend disbursements, neither of those methods are sustainable. In this scenario, using savings or debt is like using fossil fuels -- it's efficient, but the supply will run out and ruin everything eventually.
Free cash flow is how much cash a company has left "after operating the business and making necessary capital expenditures," Wright says. "(You can) pay off debt, make acquisitions, buy back your own stock or pay/increase your dividend."
So when free cash flow starts to decline, "it means the company may not have the cash available to pay the dividend," he says.
Beware of free cash flow manipulation. If free cash flow can't finance the dividend payments, the dividend is done for. Seems simple enough, right.
Unfortunately, it's not that simple. (It never is, is it?)
How a company achieves free cash flow is important, too: "If the company is forced to cut back on capex in order to maintain a FCF that is greater than its dividend, then it is likely that its dividend isn't sustainable over the long term," says Timothy Trombley, a finance professor at San Diego State University.
This harkens back to one of the problems associated with a high payout ratio: Not only can skimping on capital expenditures indicate problems with the dividend, it can cause problems in the business. In both cases, a company rejects reinvesting in its own growth in the name of fattening shareholder pockets in the short term.
Trouble repaying debt is a dead giveaway. This one seems pretty obvious, but it simply reinforces a concept that investors would do well to always remember: debt matters.
"If a company has too much debt and has a difficult time making interest payments," that's a problem, Wright says. In that situation, "continuing to pay the dividend can contribute to a company's demise as the creditors might force a company into bankruptcy. That's a bit more theoretical, as bond holders would likely force a company to reduce or eliminate its dividend well before bankruptcy would be imminent."
How'd it do in a recession? Bill DeShurko, a Covestor portfolio manager and founder of 401 Advisor, a registered investment advisor, has an altogether different way to tell if a dividend is ready to fade away.
"Look at how a stock behaved during bear markets and recessions," he says, and check how its earnings and balance sheet were affected. "A company's financials through the tech wreck, financial crisis and recent oil price plunge would be a good indication of how much cushion a company might need to maintain a dividend," he says.
By understanding the breaking point in previous crises, investors can get a general feel for the breaking point in future ones.
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