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Should I worry about too great of a dividend yield?

Posted by admin on November 4, 2008 in Dividends

Dividend yields are “sexy” numbers in the world of dividend investing (which, by in large, is an unexciting, but lucrative, subset of equity investing). Dividend investors tend to gravitate towards it because it is an easy to understand number of a rate of return at any particular period of time. But is there such a thing as too great of a dividend yield?

Let’s start at the beginning. Dividend yield is percentage determined the formula = annual dividend per share/share price. It stands to reason then that dividend yields increase in one of two manners:

1. The dividend increase is greater than the share price increase; or
2. The dividend remains constant but the share price is falling.

It is harder to affect the first than the second and the second tends to occur during down markets when share prices fall rapidly while the dividend paid remains the same. As we are all seeing when publicly traded companies hit hard times, and their share prices are re-set accordingly, dividend yields tend to shoot up followed, in some instances, by the company slashing the dividend.

This may create the impression that unusually high dividend yields cannot sustain themselves for long in down markets and the dividends slashed eventually as a cost-saving measure. But is a high dividend yield in down times necessarily a harbinger of a dividend decease?

It depends (as usual). The focus should not be on the stock price per se but digging into the statement of cash flows. At the end of the day, a company can only pay a dividend if it has the cash flow to support it. In any company’s financial statements (interim or audited), there is a line called “cash flow from operating activities.” This is pretty self-explanatory.

Now do the following if it hasn’t been done for you (I recommend MSN Money which does this substantially for you; here is an example they run on Pfizer):

Net income + depreciation/depletion – change in working capital – capital expenditure.

The sum of this is free cash flow. Free cash flow is the cash remaining after a company has spent money to maintain or buy its assets (think maintenance costs on old machines; purchasing new computer networks etc.). Its not just cash from operations you have to focus on but cash remaining after paying out its fixed over-head to keep the company running.

Now go to “net cash” which is at the bottom of the statement of cash flow and get that number. This is simply the amount of money in the bank.

You have two numbers to play with now: (i) free cash flow; and (ii) net cash.

A strong free cash flow may not necessarily mean that a high dividend yield will survive since the net cash may have declined significantly from bad investment decision (see the Pfizer example above which shows they lost almost as much money in investment as they made in operations).

A large net cash position may not necessarily mean a high dividend yield will survive if dividends paid (which is also on the statement of cash flows) is significantly higher than free cash flow BUT a large war-chest does mean that a company can continue to declare a dividend a little longer than a counterpart with equally bad free cash flow but with less cash in the bank.

(As a side-note, if you take the total amount of dividends paid to each share from the statement of cash flows and divide it with earnings per share on the income statement, you obtain the dividend payout ratio. But because earnings does not equate cash in the bank per se, the dividend payout ratio has limitations).

As also astutely pointed out by other bloggers, net cash also has its limitations. For large multi-national companies, the cash is in many banks. To get it back to headquarters involves a series of tax headaches so relying purely on net cash as a safety blanket may not get you far.

Your best scenario in down times is that the company is neither going up or down in cash flow from operations and its net cash position has not materially been affected negatively. Even if the stock price is treading downward, there is still money being generated from operations and money in the bank to support a dividend.

Those two elements (steady free cash flow and large net cash) may not mean the dividend can be maintained but it mitigates against it being slashed sooner rather than later.

To get back to the original question, it is not so much that a high dividend yield is mean that a dividend slash is near. The analysis should be whether the cash flows continue to support the current dividend payments. Flat cash flows without any exciting new product lines may flatten a stock price but it does not stand to reason that the dividend cannot be maintained.

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As one final note, some of you may have read that a class action lawsuit being launched against BCE for suspending its dividend during the pritivation process. I highly doubt that the lawsuit will succeed for a variety of reasons but it does underline again that dividend declarations are discretionary in nature and its not so much the stock price that determines the safety of the dividend but the cash flow of the company.