Dividend Safety 101
Recently on Savings and Sense we’ve been discussing the impact falling oil prices are having on oil companies and the broader stock market in general. Most recently, we talked about the potential dividend cuts coming within the oil sector and reviewed the first major one to happen via ConocoPhillips (NYSE: COP) If you’re not caught up you can find the latest episodes HERE.
Over the last few years dividend paying stocks have become all the rage. Many investors rely on dividend income as a part of their investment strategy or, in some cases, to produce their income for retirement. Unfortunately, advisers hawking these stocks or the investors who buy them, skip the homework necessary to examine the safety and reliability of their dividend income. It’s imperative that you do the homework before you commit the capital so you do not become stung when a company cuts their payout.
Below you’ll find three strategies we use at Tatro Capital when examining dividend stocks. While you’re adviser should already be doing this, for an added layer of protection you can use these metrics to review your own portfolio and check the health of the stocks you own. It’s always better to be safe than sorry.
Yield: Dividend vs Price
The yield is a company’s annual dividend payment per share, divided by its stock price. For example, a company currently trading at $100 per share and paying a $0.50 dividend per quarter ($2 annually) possesses a dividend yield of 2%.
The important thing to note about a stock’s yield is it’s dependent not just on the dividend itself but also on the share price. If the company in our example above saw its share price double to $200, that same $2 per year dividend would equal a yield of only 1%. However, if the stock performed poorly and fell to $50 per share, that $2 dividend would yield 4%. This is one of the traps dividend investors often fall into. As stocks decrease in value, whether from falling out of favor with the market or their business performing poorly, their yield increases. In fact, a change in dividend yield solely from the movement in a company’s stock price is rarely an indication to buy. If anything, it may be a warning sign.
You can find a stock’s yield by typing its symbol into any of the popular financial sites such as Morningstar, Yahoo Finance, or CNBC. The yield is typically listed in the overview area.
When looking for stocks to provide a reasonable amount of income at a reasonable price we generally look at stocks yielding between 2% and 6%. Anything less than 2% can be found in a treasury bond and anything more than 6% is a sign of danger. However, we don’t stop there, there’s two more metrics we review. A stock’s yield is a good place to start but it tells you very little about the dividend stability or health
of a company.
Payout Ratio: Dividend vs Earnings
The payout ratio tells us significantly more than the yield and can often be a better way to compare similar companies. Its calculation doesn’t rely on a stock’s price, which is constantly fluctuating, but on what the company earns in profits. The payout ratio is simply the ratio (or amount) of earnings a company pays to investors through its dividend versus what it keeps in the company to continue growing its business.
In our earlier example for the $100 stock, with a $2 per year dividend, let’s assume it produces $4 per year in earnings. To get the payout ratio we simply divide its dividend, $2, by its earnings, $4, which equals a 50% payout ratio. This percentage can change if either the dividend or the earnings change. If a company becomes more profitable the payout ratio will shrink and the company may choose to raise its dividend. If its profits begin to decrease the ratio will rise and the company may choose to stop raising its dividend, reduce it, or eliminate it altogether.
While you can find a stock’s payout ratio buried in some of the popular financial sites it’s often easier to simply divide its annual dividend by its annual earnings, or EPS. Remember to multiply the dividend by four if looking at a quarterly dividend.
When looking at companies for their dividend, we typically look for companies with a dividend ratio between 20% and 80%. This range generally includes companies who are paying enough of a dividend to show commitment to their shareholders but not so much that they’re risking the growth or longevity of the company. At the time of this writing most of the energy companies paying dividends have payout ratios far in excess of their annual income. Basic math tells you this is simply unsustainable.
Cash Flow: Dividends vs Free Cash Flow
It’s often said in business that “cash flow is king” and it’s no different when it comes to dividend-paying stocks. Publicly traded companies often have a significant difference between the earnings they report and the cash they receive in their bank account in any quarter. While this may sound odd, it’s simply due to how and when various items, such as invoices or bills not yet paid, must be accounted for. These items may increase or decrease earnings but it’s the cash in the bank that a company has available to spend that matters.
The cash flow of a company shows whether a company can comfortably pay its dividend or if the dividend is in jeopardy.
In order to find the free cash flow versus a company’s dividend payments, you’ll need to do a bit of work. On whichever site you like to get your stock quotes, search for the company you want to research then click on “Financials.” From here you’ll want to click “Cash Flow” to bring up the company’s Cash Flow Statement. There are three things here you’ll want to find:
1.) “Cash Flow from Operations,” this will be the total of the first section of the cash flow statement.
2.) “Capital Expenditures” or “Investment in Property, Plant, and Equipment,” this will be near the middle of the cash flow statement.
3.) “Dividends Paid” or “Cash Dividends Paid,” this will be towards the bottom of the cash flow statement
To find the Free Cash Flow simply do the following calculation:
Cash Flow from Operations – Capital Expenditures = Free Cash Flow
Compare the Free Cash Flow to Dividends Paid and determine which is greater.
Free Cash Flow represents the cash a company has left over after running and maintaining its business. While a company can pay more in dividends than it has in free cash flow for a short period of time, continuing to do so means it’s using its cash reserves or is issuing debt to pay its dividend. If a company resorts to either for too long it will eventually be forced to cut its dividend. Again, the case of the current energy crisis, most companies have little to no free cash flow and are therefore robbing Peter to pay Paul and will soon be forced to cut or eliminate their dividend altogether.
A case study: ConocoPhillips (COP) cuts its dividend on February 4, 2016
Should investors have known that the dividend paid by ConocoPhillips (COP) wasn’t safe? The short answer is ABSOLUTELY but why? Here’s a review of what investors would have found by doing a dividend check-up on COP before it was cut.
Prior to its dividend cut, ConocoPhillips paid an annual dividend of $2.96 with a share price of around $38.00, a dividend yield of 7.78%. This was much higher than many other oil companies at the time, a result of the stock price falling from $70 per share over the course of a year. While investors might have been lured in by a great yield there’s two more calculations to they should consider.
Below is what an investor would have seen when looking at ConocoPhillips’ payout ratio. With negative earnings the company was actually losing money for the past twelve months while attempting to pay its stockholders a dividend at the same time.
(via Yahoo Finance)
Dividends are an investor’s share of the profits, if there are no profits for long enough it’s likely there won’t be a dividend for very long.
Below is the cash flow statement from the last five quarters for ConocoPhillips. A negative free cash flow during this time while, at the same time, dividends were being paid means the company was required to dip into its cash reserves or issue debt in order to meet its dividend commitment.
Paying dividends out of cash reserves or on credit is likely not sustainable.
ConocoPhillips was a prime candidate for a dividend cut for some time before it actually happened. While investors may have been encouraged by the high yield and the fact it produces a product we use every day it’s important to remember that the safety of a dividend is just as important as its amount.
While advisers should, at minimum, be doing the work above to evaluate the dividend health of the companies their buying the truth is, most are not. Most are simply guessing when it comes to the company’s health. More often than not, they can get away with this lack of due diligence however on rare occasions, such as we’re seeing now in the energy space, this lack of homework becomes extremely costly. If you’re seeing your dividends be cut in your portfolio odds favor that your adviser has dropped the ball and it may be time to find a new adviser. If this hasn’t happened to you yet maybe it’s time for a little dividend homework yourself or it’s time for a second opinion.
At Tatro Capital we go beneath the surface to find out what’s going on with the companies we invest in. If you’d like to talk to us about a dividend income portfolio or for a free evaluation of your portfolio Call or Email us today.