When determining whether or not to buy an ownership
interest in a certain company, there are a number of things that are
often considered. Such things include the durability of the
company's business model, the company's balance sheet, valuation,
and historical earnings growth.
Another important consideration for many investors is
the strength and sustainability of the dividend that the company
pays out. Dividends are very important, as they accounted for about
42% of the total return of the S&P 500 from 1930 to 2012. The
portfolios of many dividend-oriented investors are composed of
dozens of dividend-paying stocks from a wide variety of sectors.
In this article, I will discuss the
important aspects of each company's dividend, such as the dividend's
history, whether or not the dividend can be covered by the company's
earnings, and look for clues as to whether the company can continue
paying out and growing their dividends going forward.
When talking about a
company's dividend, the first thing that normally comes to mind is
the dividend yield, which is the percentage of your capital that you
receive in return over the next 12 months, as long as the dividend
amount is not changed. A lot of investors will also use the dividend
yield as a way to help determine whether a stock is overvalued or
undervalued. If a stock is yielding more now than it ever has, then
that may imply that the stock is cheap.
When evaluating the quality of a company's dividend,
there is more to it than just the yield. Sometimes, a company's
stock may have a high yield due to poor fundamentals that have
caused the price of the stock to fall relative to its dividend
payout. These poor fundamentals could then lead to dividend cuts,
which can then lead to a drop in your net worth.
Dividend growth is another very
important factor. For one, dividend growth helps to preserve the
purchasing power of your income stream by protecting it against
inflation. Secondly, when a company increases its dividend, that is
a sign of confidence by management when it comes to the company's
fundamentals and future outlook. And third, growing dividends allow
investors to share in the benefits of growing earnings. It should
also be mentioned that dividend growth can supercharge an investor's
yield on cost over the years. For instance, Warren Buffett and
Berkshire Hathaway received a whopping 40%
yield on cost in
2012 on shares of Coca-Cola that were purchased back in 1988. This
is due to the dividends that grew almost fourteen-fold since the
Generally, I like to look at a company's average
dividend growth rate over the last 5 years in order to see how well
the dividend is keeping up with inflation. Some folks like to look
back over longer time periods, like 10 or more years, and that's
fine too. Stronger dividend growth histories are usually testaments
to strong business models, solid economic moats, and pricing power
of the companies in question.
Dividend Payout Ratio
In many cases, it's not enough to only look at the
dividend yield and the historical dividend growth rates of the stock
in question. We need to make sure that the company is making enough
money to support these dividend payments. This is where the dividend
payout ratio comes into play. It represents the percentage of
profits that the company has been allocating toward dividend
payments, as opposed to being used for buying back stock or
reinvesting into the company's operations. Generally speaking, the
lower the payout ratio, the better. This is because lower payout
ratios often indicate that there is plenty of room left for dividend
increases in the future. Payout ratios that approach or even exceed
100% may indicate dividend freezes or cuts in the future.
When looking at the dividend payout ratio, I like to
not only look at what that ratio was over the last 12 months, but
also what the company's average payout ratio over the last 4-5 years
has been. That way, if the company's current payout ratio is way
above or way below that average, then I'll know that I need to do
some further research to find out why that is the case.
Keep in mind that
companies in some industries tend to have higher payout ratios than
companies that operate in other industries. Companies with
consistently higher payout ratios usually operate in industries that
don't require large and constant investments in infrastructure in
order to keep going. They also aren't required to constantly
innovate in order to stay at the top of their fields. Because of
this, these companies can spend more of their profits on dividends.
These businesses include tobacco companies and consumer goods
Ratio = Dividends Paid / Net Income
How About That Free Cash Flow?
However, there is
more to it than just calculating the payout ratio when determining
how safe a company's dividend is. This is because the dividend
payout ratio is based on the company's earnings. However, earnings
don't pay dividends. Cash does. On top of that, earnings often
include a lot of non-cash items (depreciation, asset impairments,
patent amortization, actuarial pension gains, etc.) that have no
bearing at all on a company's ability to pay a dividend. For this
reason, it's best to calculate a payout ratio that is based on the
amount of actual cash that flows into a company over a given period
what I like to call the free cash flow payout ratio, I divide the
amount of money that was spent on dividends by the amount of free
cash flow that was generated by the company over the last 12 months.
This tends to paint a more accurate picture as to the safety of the
dividend in question. Free cash flow is calculated as the operating
cash flow minus the amount allocated to capital expenditures. All of
this information can be found on the company's most recent cash flow
This measure really
comes in handy when evaluating companies that operate in very
capital-intensive sectors of the economy. For instance, consider
companies who operate in the telecom industry. In this industry, a
lot of money gets spent on infrastructure, which can lead to huge
deductions in earnings as a result of depreciation. This can make
the dividend payout ratio, as a percentage of earnings, very high.
However, when you strip out the non-cash depreciation charges by
using the free cash flow payout ratio, a different and more accurate
picture of dividend safety is often presented.
And, as with the
dividend payout ratio described earlier, I like to look at the free
cash flow payout ratio over the past 12 months, as well as over the
last 4-5 years, to see if recent data deviates from the norm. I
generally like to see free cash flow payout ratios at 60% or below.
But, that's just a rule of thumb, and not a make or break
Free Cash Flow
Payout Ratio = Dividends Paid / (Operating Cash Flow - Capital
How To Predict Dividends Going Forward
A lot of folks would end their analysis here,
especially after looking at the free cash flow payout ratios.
However, these figures are all based on what happened in the past.
We need to find some clues as to whether the company can continue
paying steadily increasing dividends in the future. The interest
coverage ratio, the net debt to equity ratio, and expected earnings
per share growth can offer some of these clues.
Interest Coverage Ratio
The interest coverage ratio illustrates the size of
the company's pre-tax profits relative to the company's interest
payments. Generally speaking, the more debt a company has, the more
interest it has to pay, and the less that the company has left over
to pay out dividends. The interest coverage ratio is calculated by
dividing the company's earnings before interest and taxes (EBIT) by
the company's interest payments made over the same period of time.
Low interest coverage ratios (usually below 2) generally show that
the company is having a hard time just trying to make its interest
payments. That may signal dividend cuts or eliminations in the
future. The higher the interest coverage ratio, the better. The data
used to do this calculation can be found on the company's most
recent income statement.
Interest Coverage Ratio = Earnings Before Interest
and Taxes / Interest Payments
Net Debt To Equity Ratio
The amount of debt that a company has can ultimately
influence the future direction of the company's dividend. Companies
that have more debt typically pay more in interest. It should also
be noted that at some point, the company's debt will need to be
repaid. While many companies are working around this by refinancing
the debt at low interest rates, this option might not be as
attractive when interest rates head back up. When the company
finally does extinguish its debt, it may have an adverse effect on
whether it can continue paying dividends.
The net debt to equity ratio can offer us some clues
as to how much of a problem debt will be when it comes to paying out
dividends. It is calculated by subtracting the company's cash
position from the company's short and long-term debts, and then
dividing that by the company's equity position. The lower this
ratio, the better it is for not only the company in question, but
for us as investors. Ratios under one are typically considered to be
good. Information used to perform this calculation can be found on
the company's balance sheet.
Net Debt To Equity Ratio = Net Debt / Shareholder
Equity = (Short and Long-Term Debt - Cash) / Shareholder Equity
Forecasted Earnings Per Share Growth
Dividend growth can be driven by a couple of
different factors. One of these factors is the expansion of the
company's payout ratio, where the company decides to pay out a
higher percentage of its earnings or free cash flow to shareholders
as dividends. However, you can only expand the payout ratio so much.
Eventually, you must have free cash flow growth in order to pay
steadily increasing dividends. And, we all know that free cash flow
growth comes from earnings growth. To get a good idea as to the
prospects of a company's future dividend payments, it may behoove us
to look at analyst projections for future earnings per share growth
over the next couple of years. To do this, I like to consult the
projections from the analysts at S&P Capital IQ, who produce reports
that I can access through my trading platform.
In general, I prefer to see solid high single-digit
or double-digit expected earnings per share growth in the years to
come. If those projections do come to fruition, then I know that
dividend growth should not be a problem.
Now that you have
looked at the many different criteria that are used to evaluate the
safety of a company's dividend, hopefully you can now use this
information to evaluate the dividends of your favorite stock.