Is Your Stock’s Dividend Reliable? Here’s How to Check.

Aug 11, 2022 Educational

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Question: What type of stocks performed best during the first half of 2022?

Answer: Dividend-paying stocks, specifically, the highest-yielding dividend stocks, as you can see below.

Source: Seeking Alpha

That’s right, the dividend-paying stocks with the most generous yields outperformed the S&P 500 Index by a very wide margin. That’s especially true for U.S. dividend stocks, shown above at far left.

But it also held true for international dividend stocks (middle) and even for emerging markets (far right). That brings up the next, even more important question: How do you know if a stock’s dividend is safe and reliable? The answer here is a bit more complex, but let’s dive right in, shall we?

A report from earlier in the year by my friend and TradeSmith CEO Keith Kaplan pointed out that it’s not enough to seek out stocks with high dividend yields. You also need to make sure those high yields are sustainable.

In other words, you need to be able to know if a company can be counted on to continue paying (and, ideally, growing) their dividends.

One critical measure of dividend sustainability is a stock’s dividend payout ratio. This is where you may want to dig a bit deeper and do your own homework.

Look at just about any financial website and you’ll find this definition of dividend payout ratio:

Dividends per share divided by earnings per share (EPS) in %

Perhaps this calculation isn’t exactly wrong, but I believe there’s a much better, and safer, way to judge if a stock can maintain its dividend. The problem with the traditional dividend payout ratio equation above is with the E… as in earnings.

The sad truth is that companies play all sorts of games with reported earnings per share.

There are reported earnings that exclude non-recurring expenses for restructuring and other write-offs. But it’s funny how the negative non-recurring charge-offs seem to recur just about every quarter!

There are GAAP earnings and non-GAAP numbers. Another name for this is “adjusted earnings,” which roughly translates to earnings without any of the bad stuff.

And the shenanigans with reported EPS are perfectly acceptable on Wall Street, as long as they’re properly disclosed.

That’s why cash flow is far superior to EPS in my book.

Cash flow from operations measures the actual movement of money into or out of the business. It’s everything the company earns from selling stuff, minus the cost of the stuff and all operating expenses.

It’s a far more conservative measure because bean counters at corporate HQ can’t play as many games with cash flow as they can with earnings.

And you can do one better with an even more conservative measure: free cash flow (FCF).

FCF is simply operating cash flow minus capital expenditures (or capex). Capex is the necessary investment costs and expenses associated with maintaining and growing the business. These figures are easy to find on a company’s cash flow statement, or better yet, on our TradeSmith platform.

Now, here’s where you should do your own homework and calculate your own, more conservative version of the dividend payout ratio. In place of traditional EPS, use FCF per share instead.

Dividends per share divided by Free cash flow (FCF) per share in %

The result should give you a much more realistic measure of whether a company’s dividend payments are reliable long term. The lower the payout ratio, the better. That signals the business has plenty of room to continue paying dividends or even increase its payout ratio.

But a very high dividend payout ratio is a red flag.

It means the dividend could be at risk if any business slowdown occurs. If FCF declines sharply, then a company may simply not have the money it needs to pay keep paying the dividend.

And it’s best to look at the average FCF a company has generated over several years, rather than from the most recent quarter. That’s because cash flows will fluctuate due to seasonality or a slowdown in the economy.

It’s important to compare the trend in FCF to the trend of the dividends being paid over the last several years. If the dividends keep increasing but FCF is stagnant, or worse, declining, that’s a big warning sign that the dividend could be in jeopardy.

Another key metric to look at is a company’s debt.

Businesses with too much borrowed money have high interest expense, which can quickly gobble up cash flow. That’s especially true with interest rates on the rise as they are now.

An easy way to check this is to keep an eye on a firm’s return on capital (ROC), sometimes called return on invested capital (ROIC).

It measures the firm’s net income divided by the total of shareholder equity and long-term debt, which you can find on the balance sheet.

ROC tells you the percent return the business earns on its total invested capital, like the rate of return on a stock in your own portfolio. Higher is better, but once again, look at the trend in ROC over a period of time.

If ROC is low or nonexistent, that could mean the business is struggling to make money. If ROC is trending lower, it could be a red flag that profitability is in decline, perhaps because of too much debt.

Either way, low or declining ROC is a sign that the dividend could soon be cut.

One more important thing to understand is that you can’t compare the ROC of companies that operate in different industries.

Some sectors are more capital intensive than others, which will affect these ratios; you wouldn’t compare automakers, for example, to technology software companies. These are a few important ratios to check when evaluating any stock.

Next week, I will single out two similar companies to show you how to check these metrics and see which has the more sustainable dividend yield.

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