One of the most important factors in dividend growth investing is dividend safety.
The reliability of a company’s dividend payments is crucial, whether you are depending on dividends to provide growing income or to contribute to good total returns. The reason should be obvious: If you cannot rely on a dividend’s safety, you can’t rely on the other elements of the dividend growth process:
Dividend safety is even more important if you are retired and using dividends as cash income to live on. You must be able to rely on the dividends being delivered and growing at the approximate rate you expect.
How do you know if a dividend is safe?
In one sense, you cannot know if a dividend is safe: No one knows the future.
Sometimes things go wrong. Unexpected things happen.
But being unable to be 100% sure of the future is not unique to dividend safety. It applies to all of life.
Therefore I suggest that you take a probabilistic view of investing.
That means that, using information and analysis, attempt to tilt the odds in your favor whenever possible.
So in analyzing stocks, examine the available evidence for clues about what is likely to happen. As the maxim says, “History doesn’t repeat itself, but it rhymes.”
When analyzing a stock, look at things like:
- How many years a company has been increasing its dividend. See Lesson 3: The 5-Year Rule. The longer the better.
- Whether a company has frozen its dividend or is overdue for its annual increase. Check the most recent Dividend Champions document.
- How financially sound the company is, with particular attention to its debt and credit rating.
- Whether the size of annual increases has been trending up or down. Again, see the Dividend Champions document for a nice summary.
The dividend payout ratio
Many dividend investors only look at a single metric – the payout ratio – to assess dividend safety. The dividend payout ratio divides the dividend (in dollars) by an amount, typically the company’s earnings.
Payout ratio = Dividend per share / Earnings per share
Since companies need to retain at least some earnings to grow and improve, investors don’t want to see all earnings paid out as dividends. So often, a payout ratio of 50% will be considered safe, while a payout ratio of 70% might be considered risky.
But dividend safety requires deeper analysis. The safe amount of dividends to pay out varies by company. One company may starve itself if it pays out any earnings as dividends, while another company may be fine paying 70% or more of its earnings to shareholders.
Not only that, earnings may not be the right number to get a meaningful ratio. In real life, dividends are paid in cash out of the company’s cash flow. Therefore, dividends-to-cash flow may be a better measure of how safe a dividend is, rather than the percent-of-earnings ratio commonly used.
Cash payout ratio = Dividend per share / Cash flow per share
Cashflow and earnings are not usually the same in any company. They can be especially wide apart in companies that make a lot of capital investments, such as telephone companies, REITs, and others that are constantly building or purchasing more infrastructure.
Dividend safety services
Because dividend safety is of such importance, I augment my own analysis of companies on the subject.
To do that, I consult the services of an organization that focuses especially on dividend safety: Simply Safe Dividends.
Simply Safe Dividends (SSD) was formed in 2015 by my Daily Trade Alert colleague Brian Bollinger, who was previously a partner and equity research analyst for a large investment manager in Illinois.
SSD computes Dividend Safety Scores and offers a suite of online portfolio tools, stock analyses, and data for individual dividend investors.
SSD’s Dividend Safety Scores range from 0 to 100, and they take a long-term, conservative view with their ratings. Specifically, dividend risk is assessed over a full economic cycle – not just next quarter. Here is the scoring system.
Brian suggests that conservative investors stick with companies that score at least 60 for Dividend Safety.
In my Dividend Growth Stock of the Month and Valuation Zone articles, I use SSD’s scores to help make sure that a stock is worthy of even researching in depth.
Brian told me a little about how he arrives at his scores.
I believe that companies most at risk of cutting their dividends emit a number of warning signs well before a reduction is announced – sales and earnings are usually falling, the balance sheet is overleveraged, payout ratios are unsustainable, management hasn’t shown to be overly committed to maintaining the dividend, and the company needs to preserve cash.
SSD’s Safety Scores are designed to be a comprehensive measurement of dividend risk. They take into account more than a dozen key factors that influence a company’s ability to continue paying dividends. The factors include:
• Debt load
• Interest coverage
• Industry cyclicality
• Free cash flow generation
• Profitability
• Earnings and free cash flow payout ratios
• Business model quality
• Performance during past recessions
• Dividend longevity
• Near-term sales and earnings growth
The predictive power of SSD’s scores has been impressive. At this page, there is a compilation of dividend cuts since the system was introduced in 2015. An investor who stuck to stocks with scores 60 or above would have avoided 98% of them.
Dividend Safety Scores are updated weekly. A detailed explanation of how they are calculated can be found here.
Key takeaways from this lesson
1. Dividend safety can be measured. Not exactly measured, of course, because risks to a dividend involve the future. But probabilities can be placed on the likelihood that a company’s dividend is safe and not likely to be cut.
2. The safety of a company’s dividend depends on its means to pay the dividend and increase it, as well as on its policies to do so.
3. Over time, companies build up dividend resumes that show their means and intentions with respect to dividends, including dividend growth.
4. By examining a variety of financial factors, you can tilt the odds in your favor of owning companies that are less likely to cut their dividends. Stick to companies with safe dividends, even if that means giving up a little in yield.
Dave Van Knapp
Click here for Lesson 18: High Yield or Fast Growth?
This lesson was updated 12/23/2018