Sustainable Dividends Need This

By TradeSmith Editorial Staff

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Stocks with dividend yields above 100% seem too good to be true — because they are.

Imagine Tesla (TSLA) paying out $800 to $1,000 in dividends per share over the course of a year.

That doesn’t happen.

Yet, many people are deceived by lofty dividend yield quotes.

If I do a quick scan in TradeSmith Finance for U.S. stocks with dividend yields above 20%, I get the following results:

Source: TradeSmith Finance

So that you can quickly analyze any stock to determine the sustainability of a company’s dividend payments, I want to show you one critical metric: cash flow.

History is littered with bankrupt enterprises that were seemingly profitable until the day they went belly-up because they simply ran out of cash.

Analyzing a company’s cash flow isn’t difficult. (By the end of this article, you’ll know how to do it in a matter of minutes.)

From there, we can incorporate a few common-sense dividend ideas.

Lastly, we’ll cover special dividend situations and stocks such as real estate investment trusts (REITs) and master limited partnerships (MLPs).

Measuring Cash Flows

Every publicly traded company reports three separate items each quarter:

  • Income statement — Basic measure of profitability using common accounting practices
  • Balance sheet — List of all the company’s current assets and liabilities as well as their value
  • Cash flow statement — Accounting of all the cash flows into and out of the company
We want to start with the balance sheet.

At the top of each balance sheet we find current assets. Within that section, companies list out cash on hand as well as highly liquid securities, such as Treasuries, that can quickly be converted into cash.

Here’s a look at that section for Exelon (EXC).

Source: TradeSmith Finance

You can see that the amount changes over time, dropping as low as $1.1 billion. That’s fine as long as Exelon generates more cash than it spends.

But does it?

To answer that question, we need to look at the cash flow statement.

Each cash flow statement is broken into three sections:

  • Operating cash flow — The amount of cash generated by the business operations, including payments for interest, taxes, etc.
  • Investment cash flow — Money that is put toward capital expenditures such as property, plants, and equipment; acquisitions; and other general security and derivative investments
  • Financing cash flow — Debts paid or initiated, dividend payments, and other related activities
At a minimum, a company needs to generate enough cash from operations so it doesn’t use its cash reserves.

Companies like Rivian (RIVN) and Fisker (FSR) generate negative operating cash flows. However, they have raised huge amounts of capital so that they can operate with negative cash flows for years before money becomes a problem.

Biotech and pharma companies operate similarly, raising capital and then plowing it into research and development in the hope that they develop and sell a breakthrough product.

The next step is to look at investment cash flow.

Companies with heavy infrastructure, like Exelon, which operates utilities, are constantly spending money to upgrade and maintain their facilities. We see similar investments in the energy industry. It is less common in software and technology industries outside of the initial startup costs.

Lastly, we come to financing cash flow. This step isn’t too important in our analysis other than to see whether a company consistently issues more debt or shares of stock to stay afloat when cash is low.

Let’s take a look at Exelon’s cash flow statement. You can find these statements online from the Securities and Exchange Commission, the company’s website, or even within TradeSmith Finance.

I picked this stock as my example because the company generates negative cash flow (uses cash) from time to time.

In fact, take a look at the period ending in March 2021 (the middle column).

Exelon burned through $1.261 billion in cash just from its operating activities. Then, it spent another $5.079 billion on investments and capital equipment. To top it off, management paid out $374 million in dividends.

In total, Exelon spent $6.808 billion in the quarter. With only $1.1 billion in cash to end the prior quarter, management needed to raise money.

So they sold off investments to the tune of $2.908 billion + $2.266 billion = $5.174 billion, and issued $2.802 billion – $0.79 billion = $2.012 billion in net debt, for a net total of $7.186 billion.

By the following quarter, the company generated positive cash from operations. Management took the opportunity to pay back $1.217 billion in debt.

This back and forth is common in businesses, such as utility companies, that deliver value to shareholders primarily through dividend payments.

Companies that consistently burn through cash from operations and fund their dividends by issuing more and more debt are the ones we need to watch out for. That type of financing isn’t sustainable.

There is one more term I want you to become familiar with: free cash flow.

Free cash flow is operational cash flow minus any capital expenditures (capex). This is the money left over that management uses to pay back debt and/or pay out dividends.

Evaluating Dividends

Now that we know how to quickly analyze corporate filings, I want to show you the one ratio that ties this all together: dividend to free cash flow ratio.

By dividing the dividends paid by the free cash flow, we can see the percentage of cash the company put toward dividend payments.

Let’s go back to our Exelon example. If we add up all the operating cash flows and capex for the past year, we get a free cash flow of -$4.258 billion. For reference, capital expenditures are investments in plant, property, and equipment (PP&E).

Since the company paid out $1.494 billion in dividends over the past year, the ratio comes out to -0.35. This tells us that Exelon is spending more than it takes in.

That makes me question the sustainability of the stock’s 3.24% dividend yield.

Special Situations

As I mentioned at the beginning, there are two types of companies that treat dividends differently: master limited partnerships (MLPs) and real estate investment trusts (REITs).

Both of these corporate structures create what are known as pass-through entities. By paying out 90% or more of their profits in the form of distributions (they are not called dividends), these companies aren’t required to pay corporate taxes.

Consequently, the distributions vary greatly from one year to the next. In fact, the distributions to investors are based not on income but rather cash flows. That means if the company embarks on a capex spending spree, investors will receive lower payouts for a time.

For those interested in these types of investments, there are also special tax treatments for the distribution investors receive. Given the complexity of these, I highly recommend you seek the advice of a tax professional before investing in these assets.

Yield Is Relative

Is there a way to know at a glance whether a dividend yield is unsustainable?

Utility and telecommunication companies pay out hefty dividends, as do large blue-chip stocks. So it’s not uncommon to see a company like Dow Chemical (DOW) yield 4.62%.

But when you start seeing dividends above 3% in industries outside of these two or the special REIT and MLP situations, it’s definitely worth a deeper look.

How much do dividend yields matter to you when you make an investment decision? Email me and let me know. While I can’t respond to each person individually, I promise to read every message.