As dividend growth investors, our goal is to buy shares in a company that will shower us with cash for decades to come.
One of the important things to look out for in our evaluation of companies involves determining the safety of that dividend payment.
A quick check to determine dividend safety is by looking at the dividend payout ratio. This metric shows what percentage of earnings are paid out in dividends to shareholders.
In general, the lower this metric, the better. As a quick rule of thumb, I view dividend payout ratios below 60% as sustainable. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings. When a company pays out almost all of its earnings as dividends, that leaves little room for maneuvering if earnings decline. In addition, this leaves little for investing and growing the business. While there are some exceptions when it comes to certain pass-through entities such as Real Estate Investment Trusts, it is still good business practice to practice a WCGW mentality (What Could Go Wrong).
For example, dividend king Automatic Data Processing (ADP) earned $8.25/share in 2013 and paid out $4.79 in annual dividend income per share. The dividend payout ratio is a safe 56%. This means that this dividend king is likely to continue rewarding its long-term shareholders with a dividend increase into the future. This will further extend ADP’s streak of 50+ consecutive annual dividend increases.
However, there are exceptions to the 60% payout ratio rule.
For example, companies in certain industries such as utilities have strong and defensible earnings streams. In addition, they can afford to distribute a higher portion of earnings as dividends to shareholders due to the stability of their business model.
Another example have included tobacco companies, which tend to distribute high portions of net income to shareholders, since they do not need to reinvest back in the business in order to grow income. Plus, they have limited opportunities to reinvest those cashflows at high rates of return that the tobacco business already provides for them. That being said, one should probably be cautious in not putting too much weight in such enterprises, because while their revenue streams have historically been defensible and stable, there is little margin of safety in case of unforeseen shocks.
Speaking of exceptions, you should note that for certain pass-through entities such as Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs), the traditional dividend payout ratio is not a good metric for dividend safety. For REITs, instead of using earnings we evaluate profitability through Funds from Operations. Therefore, we evaluate dividend safety by using Funds From Operations Payout Ratio – which calculates the proportion of dividends over the FFO. I like to get a feel for the FFO Payout Ratio over the past decade when evaluating individual REITs. However, I am most comfortable with FFO Payout Ratios around 70% - 80% or below. For Master Limited Partnerships we look at the Distributable Cash Flow per Unit Payout Ratio.
In general, when in doubt, I like to review the ten year trends in the dividend payout ratio. If a company has paid a consistently high dividend payout, while growing earnings and dividends, I am not as worried.
I do not just look at the dividend payout ratio in isolation however. When I analyze companies, I look at the relationship between earnings, dividends and the dividend payout ratio. Evaluating the trends in these three indicators over the past decade is extremely helpful.
In general, we look for companies that grow earnings and dividends at roughly similar annual rates every year. As a result, the dividend payout ratio stays in a certain range. This depends on whether the company is in one of the three stages of dividend growth.
We want to avoid situations where management is growing dividends per share faster than earnings per share. The dividend payout ratio will go up to a certain ceiling if dividends are raised without a corresponding growth in earnings per share. This action is unsustainable, and could lead to dividend cuts down the road ( even if the dividend looks safe today).
If earnings per share do not grow, we could see a stop to dividend increases. If management keeps growing the dividend, or if earnings start falling from here, or if the company takes on too much new debt, it is possible that the dividend be cut.
Without growth in earnings per share, future dividend growth has an upper ceiling. In addition, any future growth in intrinsic value for the share price will also be limited, due to stagnating earnings. That doesn't mean however that share prices can't go higher from here (or lower), if investor expectations get overly cheerful ( or gloomy).
Another factor to consider is the quality of earnings. We want companies whose earnings are relatively immune to the economic cycles. This makes forecasting earnings easier, which allows managements to have a distribution in place that is not at the mercy of bad results during the next recession. If we have company earnings that are not defensible, but fluctuate, we may be in for a bad surprise during the next downturn. We want stability in earnings, which can then be counted on to provide stable and rising dividend income. If earnings tend to get depressed during recessions, the dividend has high risk of cut. This is why a low dividend payout ratio has to be evaluated in conjunction with trends for earnings per share and dividends per share.
Conclusion
Today we discussed the factors I leverage to reduce the risk of dividend cuts. While the risk of dividend cut will always be out there, I believe that it can be managed by the strategic dividend growth investor. The nice factor to consider is that in a diversified portfolio consisting of 50 securities, one dividend cut by 50% is easy to overcome if the rest of components grow distributions to offset the cut. In addition, by selling after a dividend cut and reinvesting the proceeds in a company that keeps growing distributions can have a positive income and psychological benefit for the investor, because it would allow them to reassess the situation with a cool head.
Having an investment plan that focuses on dividend safety, valuation, and sound portfolio management could ultimately be beneficial in including all factors listed above, and help the investor reach their goals and objectives.
