Payout Ratios Can Help You Spot Risky Dividends

By Andrey Dashkov, analyst, Casey Research

Let’s talk about dividends again…

With so much uncertainty in the market, plenty of people are looking to dividends to provide stable, passive income. That’s not a bad idea.

But this year, companies are canceling dividends on a grand scale. Year-to-date, there have already been over 160 dividend cancellations.

For context, there were over 50 dividend cancellations back in 2009, in the middle of the last financial crisis.

This time, they aren’t just obscure mom-and-pop companies. More than 20 of the cancellations this year came from companies in the S&P 500, across multiple sectors. We’re talking some of the largest businesses in the U.S., like General Motors, Disney, Boeing, and Hilton.

(To be clear, if the company isn’t paying its next dividend, I count it as canceled.)

Here’s how this dividend carnage looks compared to previous years. And remember, we’re not even halfway through this year. There’ll be more to come.

As I showed you last month, when a dividend gets canceled, investors can suffer massive losses.

This is why it’s important to hold only the safest dividend payers out there.

And there’s a tool you can use to figure out which companies fit that bill…

Watch Out for “Junk Dividends”

If you read my last dispatch, you know that “junk dividends” are high dividends that companies can’t afford to pay. As an example, I used Tupperware, which canceled its dividend last year. 

High-dividend stocks attract investors who value the steady income. But high-dividend stocks need to keep paying those dividends, or investors will go elsewhere… and the share price will get decimated.

That essay provoked some questions and comments from readers, including one that stood out to me. A reader disagreed with some of the blue-chip companies I listed with dividend payouts that looked shaky.

I see their point. Blue chips are the most established businesses out there.

However, I’m still going to call for caution when it comes to the largest dividend payers out there. After all, the COVID-19 pandemic is affecting all types of businesses, and as I showed above, plenty of blue-chip companies are canceling dividends this year. And that could lead to dips in their share price.

That’s why it’s important to not chase “junk dividends” that promise high yields. Instead, you should look for companies that can afford to pay reasonable dividends. 

So I advised you to look for companies whose dividend yield was under 7%. This is a good rule of thumb to start. But if you want to dig deeper, there’s another metric that you should know…

Another Way to Find Safe Dividends

A key point with dividends is that the company making those payments should not strain its cash flow while doing so.

One way to measure this strain is the payout ratio.

It’s the ratio of dividends paid to a profitability metric, like net income.

So if a company paid $100 million in dividends in 2019 and made $200 million in net income, its payout ratio is one-half, or 50%.

The higher a payout ratio is, the more difficult it is for a company to maintain or increase its dividends.

You can use other profitability metrics, like free cash flow to equity (FCFE), to calculate the payout ratio.

However, metrics like that are harder to find or calculate. Using net income is more convenient, and the information it provides you with is a good start.

What’s a good payout ratio? Normally, if a company can keep its average payout ratio below 80% for at least five years, that’s a good sign. It’s not a guarantee of anything, but it should give you confidence that you’re on the right track to finding a reliable dividend.

To get you started, I dug up some of the highest-dividend stocks with a payout ratio under 80%.

For good measure, I only selected companies with a market capitalization of at least $10 billion. Those are less risky than some of the high-yielding small-caps.

Source: Capital IQ

Also note that I avoided companies with dividend yields that are higher than 7%, as per my previous article. Companies with that high of a yield may be too risky. And you may not only lose your dividend – your whole position can get decimated if you pay attention to the dividend at the expense of everything else.

At this time of ultra-low interest rates and endless money printing, making sure your dividend payers can afford to keep making those distributions is key.

Just remember that this tool is a starting point. You should always do your own research, and make sure a company fits all your criteria before you invest in it. And as always, don’t bet the farm on a single trade.

Stay safe,

Andrey Dashkov
Analyst, Casey Research