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Is My Dividend Payment Safe?

Posted by admin on January 14, 2008 in Investment Products

There has been a lot of recent attention paid to dividend yield stocks on two different fronts: (a) as a safe haven to invest in during 2008; and (b) whether the dividend payment of any particular stock will be safe regardless of whether the stock price is declining or not. I wanted to address the latter since it focuses on some of the fundamentals of dividend investing.

What is a dividend? In the simplest sense, a dividend is payment made to the shareholders from free cash/profits on hand; it is surplus cash returned to shareholders. In most jurisdictions, you cannot pay a dividend if a corporation, after the payment of the dividend, “would be unable to pay its liabilities as they became due.” In other words, you have to pay the bills before you pay the dividend (keep this important point in mind). By law, a corporation cannot borrow to pay a dividend.

If you like to invest in dividend paying stock, there is always three things to keep in mind: (i) dividend yield; (ii) dividend increases; and (iii) dividend payout ratio. If you want to know whether your dividend is safe, you concentrate on (iii) primarily. A dividend payout ratio is the % of free cash/earnings/after-tax profits paid to shareholders. A dividend payout ratio of 50% means a corporation is paying 50% of its profits back to shareholders. Does this mean you want to find a stock with a high dividend payout ratio since, as a %, it would put the most money in your pocket? Not necessarily.

Companies with high dividend payout ratios are also the most vulnerable to a dividend cut. These companies are using a lot of its free cash to paying dividends. If there is short-term problems, one of the ways to get out of trouble is to cut the high dividend and use the cash saved to pay the bills. Think of dividends as your household’s “fun money.” In times of trouble, it is the first fund to be cut. Thus, high dividend payout ratio stocks are more vulnerable to a dividend cut. The Dividend Guy found a study which supports the fact that dividend stocks with high dividend payout ratios are not necessarily good stocks to own.

What is a high dividend payout ratio? It depends on the industry. On a quick and dirty analysis I also found the following (this is not an exhaustive analysis and there are exceptions):

• retail stocks tend to ratios under 30% (retail is a terrible cash flow business);
• mature tech stocks (i.e. IBM) tend to be in the 20%’s (they need cash for R&D);
• bank stocks are historically in the 30-45%’s (the current payout ratios are not representative of historical ratios);
• consumer staples (i.e. Procter & Gamble) tend to be in the 40%’s; and
• tobacco/alcohol are over 50% (they are mature industries and has no need to reinvest cash).

My rule of thumb is that I avoid a dividend payout ratio above 45% (except for tobacco/alcohol) or where the ratio is well above its competitors; anything more than 45% or that is not industry-norm means there may not be enough cash to weather hard times or raise the dividend. With obvious selection bias, Citigroup and Washington Mutual both have dividend payout ratios over 70%; many are speculating that the former will have to cut its dividend after running into sub-prime mortgage/bad commercial paper issues and the latter has cut its dividend.

Thus, if you are wondering if a company can maintain its dividend, do the following:

1. Go to Yahoo Finance/MSN Money or another financial website that will provide dividend payout ratios for you.
2. Find the stock you are interested in. Look under financial ratios and find the dividend payout ratio(sometimes referred to as just “payout ratio” under the dividend section)
3. On some sites, there is a “competitor” button that allows you to look at the financial ratios of competitors. Look these up as well.

Assuming the company is not in a mature industry, if the dividend payout ratio in excess of 45% OR well above its competitors (which I define as more than 10% more), then be a little worried; it may not be able to keep up the dividend payment or keep increasing it. I always believe that a safe dividend payout ratio should be between 35%-45% since the company has enough cash flow to meet an emergency, has room to increase the dividend and is probably growing since it is using 55%-65% of its profits to reinvest in the company.

As always, do your own due diligence before you buy. My 45% rule is a personal one. Everyone has their own investing goals so assess yours and proceed accordingly.

I am on business travel the rest of this week so the remainder of the week will be guest week with posts from an author of a personal finance book that addresses generation debt, frugality and love among other topics, a personal finance coach and a soon to be regular contributor who writes about their new year’s resolution to be financially responsible. Have a great week.