Four Signs of Dividend Safety

We will review this video from MorningStar's Josh Peters who is the Editor at their Dividend Investor newsletter service. One of the key features of dividends that we like is that they are a source of return from stocks that are always the only positive; direct money from the company's cash account to your brokerage account or mailbox. Obviously, dividend returns do NOT depend on the stock price needing to go up or appreciate in value for you to make money.

With that being said, not all dividends are safe. In the market right now, you will see companies whose dividend yields are at record highs, something we have not seen in 15 or even 20 years. So how does an investor put the benefit of a steady cash dividend payment in to his portfolio without worrying about a dividend cut? Josh summarizes the 4 key factors that you can determine to see if a dividend is safe or if there is a chance for it being cut. The four factors of dividend safety are:

• Examine the dividend payout ratio
  
• Study earnings in an economic downturn
  
• Analyze the debt to equity ratio
  
• Question extremely high dividend yields

i) Examine the Dividend Payout Ratio

The dividend payout ratio is a metric that measures the proportion of the company's earnings that is paid out in the form of dividends to shareholders. A very easy way to estimate the payout ratio is to take the stock's current annualized dividend rate and divide it in to 12 months' trailing earnings per share. We have a whole tutorial on how to calculate dividend payout ratio. Note that the payout ratio fluctuates as the company's changes its dividend payments each quarter, or because earnings fluctuate from quarter to quarter.

As a sign of caution, Josh Peters tells us to become suspicious of a company whose dividend payout ratio exceeds 60 - 70%. At that point, earnings only need to fall by 30 - 40% before dividends are no longer funded by earnings.

ii) Study Earnings in an Economic Downturn

You cannot examine a company solely by its dividend payout ratio. The second factor to analyze is to study earnings when the economy is going downwards. A recession reduces purchasing power for most consumers & corporations, that's why earnings of such companies tend to go down. But this should not affect companies who supply necessities of life such as Costco Wholesale or Kraft Foods because no matter recession or not, everyone has to have a meal on the table. For such companies, you're not going to see earnings drop 10 - 15%, but you most likely won't see a company whose earnings drop 80% in a recession. Thus it is important to analyze the earnings trend of companies before you decide to buy their stock.

iii) Analyze Debt to Equity Ratio

The third most important factor to look at is to inspect the Balance sheet to see how much does a company owe to creditors. If a company has lots of debt and a large portion of its cash earnings each quarter are paid in interest payments, this signals a high chance the dividend will be cut or it is not sustainable. As a general rule of thumb, a company's debt to equity ratio should NOT exceed 50% according to the video. However we at Best Dividend Paying Stocks recommend this ratio not exceed 40% to make things more safe for dividend income investors.

iv) Question Extremely High Dividend Yields

During the economic downturn of 2008 and 2009, most stocks lost almost 50% or more of their value due to a bearish stock market. If the dividends on such stocks have NOT been cut, the yields on such stocks become accidentally very high yielding. However, the stock market does a pretty good job of sniffing out stocks that have very high & risky dividend yields. For instance, when you come across a stock that has a dividend yield of say 15% or 25%; a really sky high dividend that looks very juicy, chances are pretty good that the company is in some position of financial distress and that dividend can't be maintained.