3 signs that a stock’s dividend could be at risk
Investing in dividends is not as simple as choosing the most profitable stocks. Companies can cut dividends – even those that have increased their dividends for decades – and choosing investments based solely on performance can be a recipe for disaster.
What is a dividend?
A dividend is a way for a company to return money to investors, rewarding them for owning stock. A steadily increasing dividend is a clear sign that a business is growing successfully – the type of business income that investors would most like to own. The increase in dividends is a signal to investors that management believes the future of the company is bright. And management teams usually don’t want to cut dividends, so they try not to push them to unsustainable levels. But that doesn’t mean dividends will never be cut.
They do.
And when they are cut, investors are not happy. They lose the payment and get an indication that the business is in trouble. Investors should keep their eyes peeled for dividends and look for companies that balance high yield with the ability to sustain the payout (and hopefully grow it over time).
There is no guaranteed way to protect yourself against a drop in dividends, but there are signs you can look for to determine if a dividend is in danger. Here are three clues that you should pay close attention to.
1. Payout ratios
The ratio most often considered to assess the strength of the dividend is the The payout ratio, which compares dividends to profits. This is a very good start, because a company that pays more dividends than it earns is theoretically not able to support its payment.
The term “theoretically” here is important, however, because dividends are not actually paid out of profits. They are paid out of cash.
For example, real estate investment fund (REITs) often pay dividends that exceed their earnings due to non-cash depreciation charges. The structure of the REIT is specifically designed to own physical buildings, which are subject to significant depreciation expense. Depreciation reduces an asset’s value a bit each year to account for wear and tear (and possible obsolescence, in some cases), and those costs go through the income statement. But this reduction is really an accounting tool – no one is physically taking that money from the business. So while REITs have huge depreciation expenses, these costs do not impact the cash flow they generate.
The above graphic for Real estate income (O -1.86% ), a flagship REIT with a 27-year history of annual dividend increases, shows the difference here. This is an extreme example, but it applies to all businesses.
This doesn’t mean that the payout ratio doesn’t make sense – in fact, it’s a big warning sign that trouble could be brewing. But that shouldn’t be the only thing you’re looking at. You should also review the cash dividend payout ratio, which examines dividends versus cash flow. A high ratio on either or both of these measures should put dividend investors at ease. Anything close to 100% should be of particular concern.
2. Balance sheet
The payout ratio and the payout ratio of cash dividends, however, are not the only issues to consider when evaluating dividend safety. They are only one way to see if a company is having difficulty or difficulty in covering the cost of its dividend. Yes, that alone could lead to a cut, but a cut is more likely to occur if there are other factors involved. A key place to look for weakness is the balance sheet, the financial base on which businesses are based.
To take ExxonMobil (XOM 0.09% ) and Eni (E -1.60% ), for example, two of the world’s largest integrated energy companies. Exxon has a long history of being fiscally conservative, while Eni has a history of being more aggressive with its balance sheet. The table below compares the debt ratios, a measure of how much debt a business uses, and tells the story quite well. But here’s the thing: volatile energy prices are often the driving force behind these companies.
When oil prices fall like they did in mid-2014 (notice the red line on the graph), Exxon can rely on its balance sheet to support its business and dividends while its earnings are low (and that it is not able to cover the dividend). In fact, the oil giant’s debt-to-equity ratio rose slightly during this difficult time, but it did not reach a worrying level. Exxon has continued to increase its dividend each year, a feat that few of his closest peers have been able to achieve. Eni had much less room to maneuver as it was already heavily in debt, which is why the 2014 oil drop resulted in lower dividends. When faced with difficult market conditions, heavily leveraged companies may have no choice but to reduce their dividends so that they can use their cash for other purposes.
It is often the best choice for a company, even if it is a disaster for the shareholders who have come to rely on its dividend. For example, in 2016 Kinder Morgan (KMI -1.02% ) had to choose between its dividend and the financing of growth projects. The half-way the company tends to make more aggressive use of leverage than many of its peers (see debt owed to EBITDA ratios in the graph below) and tapping into the capital markets at that time would have been costly. Management therefore reduced the dividend by 75%. It got him through a tough time, and it is now back to increasing its dividend.
Here’s the thing: Kinder Morgan had a long history of steady dividend increases behind it. And management was actually telling investors to expect dividends of up to 10% in 2016, just months before the cut was announced. If you just watched the story here (and listened to the management) you would have been caught off guard. If you had also factored in the company’s high debt metrics, you would have been rightly worried and perhaps avoided the company. Also note that Kinder Morgan’s cash dividend payout ratio was above 100% in 2015 and 2016, showing the value of layering these tools on top of each other.
3. Interest charges
The strength of a company’s balance sheet is an important indicator, but you’ll also want to consider how well it can handle the debt it has incurred. For this you should look times the interest earned, which compares interest expense to income. The higher the number, the better, because it means that the interest costs are better covered. Interest earned by Kinder Morgan was 3 in 2014 before falling to less than 1.5 in 2016, a much more worrying figure. Every business is different, but you’ll want to research changes and consider what the change actually indicates. For Kinder Morgan, this was another sign that market conditions were causing serious financial stress.
But how about General Mills (GIS 0.06% ), where the number of times the interest earned went from over 8 to about 5? This decrease is due to a massive increase in debt. The graph below looks pretty worrying, until you think about the situation a bit: Debt has been used up buy Blue Buffalo, an industry-leading healthy pet food maker expected to help General Mills grow its business. And just as important, covering the interest cost 5 times is still pretty solid. Additionally, the company has specifically stated that debt reduction is a key goal. In fact, he plans to keep the dividend stable for a few years while he focuses on that goal.
Now when a company that has a long streak of annual dividends rises behind it suddenly keeps the dividend stable, you have to stop and take a look at what’s going on. (By the way, that’s a good fourth signal to watch.) But in this case, General Mills has been open about what it does and works in a position of financial strength because it can still easily cover its costs of interests. . No particular need to worry, although you should be keeping a close eye on the Blue Buffalo onboarding process.
General Mills tends to make heavy use of leverage overall, but due to its business model (selling many small ‘necessity’ food items to many end customers) it has been able to to bear the weight of this debt relatively easily, as indicated by times the interest earned.
More tools for your toolbox
Now for the bad news: There is no sure-fire way to determine what a company is going to do with its dividend. This decision rests with the board of directors. All you can do is pay close attention and use the information that is available to you to give you an idea of the risk you face on the dividend front. Ideally, you should just avoid situations where the dividend doesn’t look particularly secure.
A high payout ratio (relative to earnings and cash flow), heavy leverage, and low interest coverage are all primary indicators of high risk. As you check more and more, your risk of falling dividends increases more and more. While all income investors are tempted by high returns, if a high return comes with too much risk, it’s probably not worth buying the stock. These tools can help you make that call.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.