Wednesday, December 21, 2011

Margin of Safety in Dividends

Benjamin Graham is the father of value investing. His strategy was focused on purchasing securities where the price was much lower than the total liquidation value of the corporation. This concept of purchasing stocks with a margin of safety has made him, his investors and the investors of his followers billions of dollars in profits. The real profits from this powerful concept were realized by Warren Buffett, who purchased stock in wide-moat companies at a fraction of what their future value was going to be.

Dividend investing is a form of value investing, where investors do not realize all of their return all at once, but rather on regular and consistent intervals. Dividends provide a direct link between the financial performance of a company, and the returns of its shareholders. Sometimes the market does not recognize that certain firms are more valuable for extended periods of time, even if their earnings are higher and valuations are cheap. With dividends, value investors realize a return that puts them closer to realizing the intrinsic value of the stock, no matter what the market or the stock price does.

Not all dividend stocks are attractive bargains however, which is evidenced when applying certain quantitative and qualitative criteria. In addition, investors should analyze whether the dividend payment is sustainable. There has to be an adequate margin of safety in dividend coverage from earnings or cashlows, which would ensure prompt payment of distributions even if there was a temporary fluctuation in operating performance.

I typically look for a margin of safety in dividends in corporations to be 50%-60% or below. This means that the dividend payout ratio should not be over 60%, 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. There are some exceptions, where investors need to look beyond dividend payout ratio in order to evaluate dividend sustainability for Real Estate Investment Trusts, Master Limited Partnerships or Business Development Corporations to name a few. For REITs, investors should look at Funds from Operations (FFO). FFO is defined as net income available to common stockholders, plus depreciation and amortization of real estate assets, reduced by gains on sales of investment properties and extraordinary items.

For example, in 2010 Realty Income (O) distributed $1.722/share in dividends, whereas earnings were $0.92/share. It’s FFO per share was $1.83/share however. Check my analysis of this REIT.

Some companies with safe dividends include:

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), provides supplemental health and life insurance. The company earned $4.95/share in 2010, and its annual dividend is $1.32 /share. The dividend payout ratio is 26.70%. Yield: 3.10% (analysis)

Medtronic, Inc. (MDT) manufactures and sells device-based medical therapies worldwide. The company earned $2.86/share in 2011, and its annual dividend is $0.97/share. The dividend payout ratio is 33.90%. Yield: 2.70% (analysis)

McDonald’s Corporation (MCD), together with its subsidiaries, operates as a foodservice retailer worldwide. The company earned $4.58/share in 2010, and its annual dividend is $2.80 /share. The dividend payout ratio is 61.10%. Yield: 2.90% (analysis)

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company earned $4.18/share in 2010, and its annual dividend is $1.46/share. The dividend payout ratio is 34.90%. Yield: 2.50% (analysis)

Margin of safety in dividends is just one of the characteristics I look in a stock before analyzing it and eventually initiating or adding to my position in it. Nevertheless it is important to purchase shares in companies that can grow dividends and produce sustainable distributions for decades, while minimizing the risk of a dividend cut.

Full Disclosure: Long all stocks mentioned above

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