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How to Anticipate a Dividend Cut

Dee Gill

Exelon’s (EXC) dividend cut last week shouldn’t have surprised anyone who had been watching the company’s fundamentals. Dividend payments were already outstripping earnings and cash when the company announced its third quarter results in November. Several other companies are in the same boat now. Should we expect dividend cuts from them also?

Exelon’s experience illustrates a trend that tends to happen just before a dividend cut. Its dividend payout ratio, which measures the amount of profits against the cost of the dividend payment, had risen above 1. So had its cash dividend payout ratio, which shows the portion of cash flow, after capital expenditures and preferred dividends payments, that a company uses to make its common stock dividend payments.

EXC Payout Ratio TTM Chart

We set the YChart StockScreener to find large companies approaching similarly high ratios and considered what these numbers might mean for their future dividend payments. Here are a couple of interesting ones.

Telecom company Windstream (WIN) buys shareholders with a very high dividend yield, and it’s more than 10% at the moment. Dividend payments have exceeded the company’s earnings every quarter for more than five years, and recently, its cash dividend payout ratio exceeded one also.

WIN Payout Ratio TTM Chart

Wall Street has worried about an imminent Windstream dividend cut for a long time, especially since there’s been little happening to make investors optimistic about the core business. The occasional windfall, like a reduced tax rate recently, has helped the company continue its big payouts long after many (including us) thought possible. Corporations can fund dividends from debt, and Windstream has a lot of that. Its fellow telecom company CenturyLink (CTL) also has a high payout ratio of about 2.8, but it has strong, improving free cash flow that covers the payout.

Burger chain Wendy’s (WEN) runs some of the highest dividend ratios out there, with a payout ratio of 7.6 and a cash dividend payout ratio of 2.5. But it’s a less alarming situation when the company is growing fast, as investors think Wendy’s is about to do. Compare the trend in its share price versus Exelon’s in the past six months, as seen in a stock chart.

WEN Chart

Wendy’s hasn’t demonstrated great growth yet, and in fact has frustrated a lot of shareholders with miniscule earnings for several years. But it is forecasting 25% earnings per share growth in 2013 and has been confident enough to raise its dividend a tad for today’s 3.2% dividend yield. It’s also buying back stock, which will reduce the number of shares that get dividends.

Charts alone can mislead, and high payout ratios can hide very good performance. American Eagle Outfitters (AEO), for example, is growing like mad and its share price is up 47% this year. The company’s dividend payout ratios are high because it shared its good fortune with shareholders recently by paying them a special dividend.

So a high payout ratio isn’t perfect in predicting dividend cuts. But it’s sometimes a very bad sign.

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com.

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