How to Tell If Your Dividend Is in Danger
As an investor focused on income, one of the most important factors I look at is dividend safety.* My proprietary 10-11-12 System that I use focuses on companies that meaningfully raise their dividends every year.
If a company cuts its dividend, that can cause the entire portfolio to decline (from an income perspective). Which is unacceptable.*
In fact, dividend safety is so important to me that I created a weekly column for Wealthy Retirement called the Safety Net. (In it, I analyze the dividend safety of companies suggested by readers.)
So what do I look at? Let me start by telling you what not to focus on…
Who Cares About Earnings?
You may be shocked to learn that when it comes to dividends, I usually don’t pay close attention to earnings.
You see, earnings can be – and often are – manipulated. Management can push a sale forward or backward in order to ensure the revenue is recorded when it will be most beneficial.*
For example, let’s say it’s the end of the quarter and management knows it will already be able to meet Wall Street’s expectations for the quarter. On the last day of the quarter, the company lands a big contract. It may decide to hold up the paperwork until the following day (the next quarter) so that it starts the quarter off with a large chunk of revenue.
There are also noncash expenses like depreciation that are included in earnings. Here’s what I mean…
Say a company generated $1 million in revenue, had $500,000 in cost of goods sold and another $200,000 in administrative expenses. Its earnings from operations would be $300,000.
But if the company bought a $500,000 piece of equipment three years ago, it may be able to write off $100,000 in depreciation expenses each year for five years. So, this year it takes off $100,000 in depreciation expenses, lowering income to $200,000 – even though it didn’t lay out that $100,000 this year. It’s a noncash expense. It lowers income (and, incidentally, taxes), but doesn’t result in a cash outlay.
So you can see that earnings don’t really tell the whole story.* That’s why I focus on cash flow.
A Stronger Metric for Judging Dividends
Cash flow accounts for all of the cash that comes into and leaves the company. Remember: dividends are paid with cash – not earnings.
You can see from the statement of cash flow that the $100,000 in depreciation is added back to figure out the actual cash flow for the quarter. So although the company reported earnings (net income) of $200,000, it actually generated $300,000 in cash flow.
This is important because if we are analyzing the safety of the dividend, we need to know how much cash the company makes… not how much profit it’s reporting with accounting gimmicks built in.*
If the company paid out $200,000 in dividends, someone who only looks at earnings may say, “The company is paying out all of its earnings in dividends. That’s not safe.” But someone looking at cash flow would say, “The company is paying out 66% of its cash flow in dividends. That’s pretty safe.”*
The percentage of earnings (or cash flow) that is paid out in dividends is called the payout ratio. Most people use earnings as the basis for calculating this. But for the reasons I just talked about, I use cash flow. It’s simply a more accurate picture of the company’s ability to pay the dividend.*
Generally speaking, I like to see a payout ratio of 75% or less.* Some companies and industries will be different, but that’s a good general rule. If you get above 75%, it doesn’t mean a dividend cut is imminent – but you should start paying close attention.
If you agree with me that dividend safety is one of the most important elements in income investing, then you should have a clear understanding of cash flow, the payout ratio and how to tell if your dividend could be in danger.
P.S. Dividends can and do get cut. And when it happens, it deals a double whammy to shareholders as the stock price inevitably declines. In fact, just last week I gave Wynn Resorts’ dividend a “D” rating… and, guess what? It slashed its dividend by 67% on Tuesday. Shares plunged by over 15%.
Of course, it takes time to analyze the safety of all your individual holdings.
*The views and opinions expressed in this piece are those of the author and do not necessarily reflect the official position of professional analysts.
About Marc Lichtenfeld
A master of the steady, reliable science of income investing, Marc’s commentary has appeared in The Wall Street Journal, Barron’s and U.S. News & World Report. He has also appeared on CNBC, Fox Business and Yahoo Finance. His book Get Rich With Dividends: A Proven System for Double-Digit Returns achieved best-seller status shortly after its release in 2012. He captures the hearts and minds of readers approaching their golden years in his daily e-letter, Wealthy Retirement.