(Note: This Lesson was revised on September 1, 2016. The principal revision was to introduce Simply Safe Dividends, a service that measures dividend safety. Other changes update information contained in the original Lesson.)
As we discussed in earlier lessons, dividend growth investing is based on two simple principals:
• The stock has a dividend of sufficient size to begin with (meaning when you buy it); and
• The dividend is increased regularly.
One of the most important factors in dividend growth investing is dividend safety. Obviously, the reliability of a company’s dividend payments is very important, whether you are depending on dividends to provide growing income or contribute to good total returns.
How do you know if a dividend is safe?
In one sense, you cannot know: No one knows the future.
You can never be 100% sure that every company you own will increase or even maintain its dividend every year.
Sometimes things go wrong. Unexpected things happen.
Because I do not know the future, I take a probabilistic view of investing.
That means that, using information and analysis, I attempt to tilt the odds in my favor whenever possible.
So in analyzing stocks, we examine evidence for clues about what is likely to happen. As the maxim says, “History doesn’t repeat itself, but it rhymes.”
So we look at things like:
• How many years a company has been increasing its dividends. See Lesson 3: The 5-Year Rule.
• The independence of a company’s dividend from its performance in the stock market. See Lesson 7: Dividends are Independent from the Market.
• Whether a company has frozen its dividend (that is, not increased in more than a year).
• How much debt the company carries.
• The dividend payout ratio. (Meaning: How much of a company’s earnings or cash flow is it paying out in dividends?)
• Whether the size of annual increases has been trending up or down.
• How sound the company is financially.
Because dividend safety is so important, I also consult the services of two organizations that rate dividend safety. Let me introduce them to you.
Safety Net Pro
Safety Net Pro is a database and dividend-rating service. It is a unit of Wealthy Retirement, which in turn is part of The Oxford Club.
My colleague on Daily Trade Alert, Marc Lichtenfeld, maintains the database and systems that rate dividend safety. Marc is the Chief Income Strategist for The Oxford Club.
Safety Net Pro is a quantitative system for rating the safety of stock dividends. Using objective data and algorithms that Marc developed, the system rates the probable safety of each company’s dividend.
By analyzing cash flow, payout ratios, dividend track records, and other variables, Safety Net Pro assigns each stock an A-F rating on the safety of its dividend. An A rating suggests that the dividend is safe and unlikely to be cut. An F means that there is high risk of a reduction in the dividend.
The Safety Net Pro system considers:
• Payout ratio based on cash flow
• Cash flow growth
• Past dividend cuts
• Analyst estimates
• Other relevant metrics
Here is the rating system:
In assigning ratings, Marc tells me that there is no quota or required percentage for each rating. The companies are scored based on objective criteria and assigned the appropriate rating accordingly.
In other words, stocks are not divided into 5 tiers with 20% of stocks in each tier. Instead every stock gets the grade it deserves.
Note that Safety Net Pro uses cash payout ratios rather than earnings payout ratios.
Let’s talk about payout ratios. The dividend payout ratio divides the dividend (in dollars) by an amount. The amount used as the divisor most commonly is earnings. That gives you the earnings payout ratio.
The formula is Earnings Payout Ratio = Dividends per Share / Earnings per Share. So if a company earns $1.00 per share and pays out $0.50 in dividends, it would have an earnings payout ratio of 50%.
For example, as shown in a recent Dividend Growth Stock of the Month article, Boeing (BA) pays out 59% of its earnings as dividends. So its earnings payout ratio is 59%.
The intent in examining payout ratios is obvious: We want to see that earnings cover the dividend well, and that the company has money left over after paying the dividend for making investments in its own future.
In real life, of course, dividends are paid in cash. While the following may sound odd, a company can have low “official” earnings but high cash flow, and vice-versa. That can happen because of the accounting rules that dictate how companies must compute reported earnings.
Here is an example. One of the reasons that a company’s cash flow may be higher than its earnings is that the earnings number gets reduced by depreciation charges. Depreciation is a non-cash charge against earnings. That is, it is a book-keeping subtraction that does not represent cash actually going out the door in the year that the charge is recorded. The money was actually spent years ago.
The purpose of depreciation is to spread out the cost of, say, a plant over its useful life, which may be 20-30 years. Companies are required to depreciate their plants and equipment every year until the original cost is written off, even if the usefulness of the property is not being impaired. Many capital assets last longer than the depreciation period.
As a result, a number of capital-intensive businesses such as telecommunications companies and real estate investment trusts (REITs) sometimes have lower official earnings than their cash flows. The earnings are reduced because capital equipment and facilities are being depreciated on the books. But the companies may have healthy cash flows that allow them to pay higher dividends than their earnings might suggest.
AT&T (T) is such a company. Its business requires a lot of capital, so every year its reported earnings are diminished by the depreciation of equipment purchased years ago.
As shown below in blue, AT&T’s earnings payout ratio often exceeds 100%, which sounds impossible. But its payout ratio based on cash flow, shown in orange, stays pretty steady at around 60% – 70%. In other words, the company has enough cash to pay its dividend each year.
So a payout ratio that first seems alarming – like more than 100% of earnings – may actually be pretty safe. Safety Net Pro’s dividend safety grade for AT&T is B – meaning that the dividend is safe and bears a low risk of being cut.
So it is important to interpret each company’s cash situation. Companies can’t indefinitely pay dividends that exceed cash flow.
There are about 1000 stocks rated in the Safety Net Pro database. They added several hundred stocks this year (2016), increasing especially their coverage of financial companies.
For more information on Safety Net Pro, click here.
Simply Safe Dividends
The second source of dividend safety ratings that I use is Simply Safe Dividends. This organization was formed in 2015 by Brian Bollinger, who was previously a partner and equity research analyst for a large investment manager in Illinois.
Simply Safe Dividends computes Dividend Safety Scores and offers a suite of online research tools, stock analysis, and data for individual dividend investors. Brian states that Dividend Safety Scores are akin to credit ratings, except they are applied to dividends rather than bonds.
Essentially, Dividend Safety Scores help answer the question, “Is the current dividend payment safe?”
Dividend Safety Scores range from 0 to 100, with 50 being average. Here is the complete 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 articles, I will evaluate and color the Simply Safe Dividend scores exactly as shown above.
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.
Simply Safe Dividend’s Dividend Safety Scores are a comprehensive measurement of 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
• Return on invested capital
• Free cash flow generation
• Earnings and free cash flow payout ratios
• Business model quality
• Performance during recessions
• Dividend longevity
• Near-term sales growth
• Near-term earnings growth
Brian notes the predictive power of his Dividend Safety Scores. For example, at the times of their dividend reduction announcements, Kinder Morgan (KMI), ConocoPhillips (COP), BHP Billiton (BBL), and National Oilwell Varco (NOV) all had scores below 20 for Dividend Safety.
The current Dividend Safety Score for AT&T, discussed earlier, is 93. So again under this system, we see an example of a capital-intensive company with a very safe dividend even if it might have a high earnings payout ratio.
Dividend Safety Scores are updated weekly, and they do change as new information becomes available. To access Simply Safe Dividends’ home page, click here. For more information about the calculation, use, interpretation, and track record of Dividend Safety Scores, click here.
– Dave Van Knapp