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How to Examine Safety of a Dividend Stock?

Long term Income Investors desire high quality stream of dividend payments from blue chip stocks that have been around for decades, have strong business models and generate recurring free cash flows every year after paying salaries and capital expenditures. They should also have competitive moat that makes it difficult for new entrants to compete.

But how do you avoid companies that are about to cut their dividends leading to long term capital impairment? In fact, dividend cuts are the #1 reason investors stop buying dividend stocks.

As the American business magnate John D. Rockefeller once quoted, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” Dividends are crucial to successful long term investing, and even more important to retirees who live off the income.

In this article, we will go over 10 criteria that investors can analyze before buying a dividend stock. Any red flags in these criteria typically should signal as a warning sign a dividend cut is about to materialize.

Table of Contents

This article is broken down in to sections, feel free to jump to the area that interests you.

1) Dividend Payout Ratio

Dividend payout ratio is the #1 most important factor in analyzing dividend stocks. It measures how much of a company’s earnings or free cash flow is paid out in the form of dividends. It can be calculated in 2 ways.

a) Dividends per Share / Earnings per Share:

This method takes annual dividend payments divided by total shares outstanding and divides in to earnings per share. Earnings per share is defined as a company’s net profit divided by total shares outstanding.

The lower this percentage, the better as it means the company has more cash flow left over to grow dividends or grow the business. It is also prudent to look at the payout ratio over several years, as a company’s EPS might be temporarily affected by a 1 year sale of business gain, or a large impairment that lowers earnings.

b) Dividends per Share / Free Cash Flow:

This method in our view is stronger because it factors in free cash flow (FCF). FCF is cash flow from operations minus capital expenditures needed to keep the business running. Cash from operations is what’s left over after paying all employee salaries, benefits, rent and other expenses.

In simpler terms, FCF is a better indicator of cash because it cannot be manipulated like earnings per share by accounting methods such as depreciation/amortization, gains or losses from investments, impairment charges or fair value revaluations.

2) Interest Payments

The higher debt a corporation carries, the more cash flow goes towards interest payments serving that debt. If there is a large debt load that is growing, dividend cuts eventually will become inevitable especially during a recession or economic downturn. The effect of interest payments is measured by interest coverage ratio.

Interest Coverage Ratio = EBIT (Earnings before Interest and Taxes) / Interest payments

Say a company has earnings of $10 million in 2020 and pays interest on its debts of $3 million. The interest coverage ratio is:

$10 million / $3 million = 3.33

As a rule of thumb, interest coverage ratio below 2 is too low. The higher the ratio, the better. In the above example, the company has a ratio of 3.33 which is considered quite healthy.

3) Leverage Ratio

Leverage ratio tells investors whether a company carries too much debt which could be a precursor to dividend cut. Debt is a good tool if used properly. As an example, if a company earns a higher rate of return from operations versus the interest it pays on its debts, that is a good strategy for long term growth.

However, high debt loads can lead to credit rating downgrades and/or interest rate hikes from banks as risk increases. The best way to measure leverage ratio is the classic accounting formula, debt to equity ratio.

Debt to Equity Ratio = Total Liabilities (Short and Long Term Debt) / Total Shareholders’ Equity

As an example, for fiscal year 2019, Microsoft carried long term debt of $66.7 billion on its balance sheet. It also has a shareholder’s equity of $102.3 billion. What is the debt to equity ratio?

Debt to Equity Ratio = $66.7 billion / $102.3 billion

Debt to Equity Ratio = 0.65

This means for every dollar in equity, Microsoft has 65 cents of leverage. This is respectable because there is more equity in the stock than debt. A ratio of 1 means creditors and shareholders are on equal footing in the company.

A high debt to equity ratio (greater than 2) means the company is highly leveraged and holding the stock is a risky bet, especially come economic downturns.

4) Dividend Yield

This one is obvious, a company that yields a high dividend is in danger of cuts because most probably its share price has dropped significantly and the business is not doing so well. Case in point, department store Macy’s was yielding a dividend of 9.8% as of November 2019.

In March 2020, the company suspended its quarterly dividends, and its stock has dropped precipitously from a high of $55 in July 2015 to $5.36 as of April 2020.

This is because not only do department stores face tough competition from Amazon but they also operate in razor thin margins. An economic shut down presented by Covid-19 has forced Macy’s to close stores and is nearly heading towards bankruptcy.

We do want to emphasize there are plenty of high yielding dividend stocks that pay in excess of 5% annually and have stable business models, strong free cash flows and economic moat that cannot be easily duplicated.

We review some of them on this site including AT&T, AbbVie, Enbridge and Exxon Mobil. Here is how the dividend yield is calculated.

Dividend Yield = Total annual dividends / Share Price

5) Book Value

Book Value measures how much a company is worth at any given point in time. It subtracts outstanding liabilities from total assets a company owns to arrive at shareholders’ equity. This information is found in balance sheet posted on the Investor Relations website.

Assets showing on the balance sheet are net of accumulated depreciation while liabilities will always be owing. The formula for calculating book value is:

Book Value = Total Assets – Total Liabilities

To calculate intrinsic value of a stock, investors typically use the book value as a starting point. If the total market capitalization of a stock is less than the book value on its balance sheet, this warrants further investigation to find out why the company is selling for cheap.

Please be aware that not all undervalued stocks are a buy because the underlying business could be under the threat of extinction due to competition like Amazon, Netflix, etc.

6) Earnings Growth

To successfully pay a dividend for years to come, companies need to deliver positive earnings growth over the long term. Examples are the S&P 500 dividend aristocrats that have consistently grown their dividends for at least 25 years, and investors would be hard pressed to find any single aristocrat that hasn’t grown earnings per share during this same time frame.

Below is a summary of Microsoft Stock’s growth metrics from Reuters. It shows the company has grown its earnings per share at 12.55% annualized over the last 5 years, and has grown its revenues at a 7.7% compounded annual growth rate (CAGR).

Microsoft has also grown its dividend at 9% annualized over the last 3 years. This is an example of a strong stock that is growing earnings, dividends and its stock price at the same time.

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