Thursday, October 12, 2017

How to determine if your dividends are safe

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.

For example, dividend king 3M (MMM) earned $8.16/share in 2016 and paid out $4.44 in annual dividend income per share. The dividend payout ratio is a safe 54%. 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 3M's streak of 59 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 include 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. For example, Altria is expected to earn $3.26/share in 2017, and it is scheduled to pay out at least $2.64/share to shareholders for a payout ratio of 75%. If we ignore the results for 2016, since they were tainted by one-time accounting gains, we could see that the payout ratio was 79% in 2015, 76% in 2014 and 79% in 2013.

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.

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 dividned 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.

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).

For example, Procter & Gamble (PG) has been unable to grow earnings per share over the past decade. However, the company has continued growing its dividend every year. As a result, the dividend payout ratio is at 73% today, which is up from 46% in 2009. If earnings per share do not grow from here, we would 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.

In another example, we have Target (TGT) with an annual dividend of $2.40/share against expected earnings of $4.51/share. The stock looks cheap at 12.70 times forward earnings. However, the company has been unable to grow earnings per share since earning $4.53/share in 2013. The future expectations for earnings growth are dim as well. 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.

For example, a few years ago, we warned readers against investing in BHP Billiton (BBL). The company had high earnings and low P/E and a low dividend payout ratio. However, earnings from commodity producers are not as defensive as earnings from consumer staples or utilities companies. We further discussed this idea in the article that “Not all P/E ratios are created equal”. If I can make it relevant for this post, the topic would be “not all dividend payout ratios are created equal”.Today, many dividend investors are buying airline stocks, citing low P/E ratios and low payout ratios. However, if earnings get decimated during the next oil spike, or another unfortunate event, those dividends may go on the chopping block.

Full Disclosure: Long TGT, PG, MO, MMM

Relevant Articles:

How to analyze investment opportunities?
Margin of Safety in Dividends
Not all P/E ratios are created equal
Rising Earnings – The Source of Future Dividend Growth
How to read my stock analysis reports

Apparently I was included in the Top 100 dividend blogs in the world too. Thanks for reading!

Popular Posts