From the Mailbag: How to Know If A Dividend Is Sustainable
I love getting questions from you all. It makes me look at companies I might not dig into otherwise. It also reminds me to circle back on topics we haven’t hit in a while. Today, we revisit a question from Doc about how to tell if a dividend is safe or sustainable.
Before we get into that, don’t forget about our first Dividend Digest live call next Thursday at 2pm EDT. I will take you through my full strategy for both building wealth and generating income. Plus, you can ask me questions during the event as well. All the details are on the events page in the online community.
Now onto Doc’s question:
I am fairly new to dividend investing and have tried to determine if the AMERISAFE. Inc. (AMSF) dividend is sustainable. AMSF pays three small and one large, year-end dividend that total more than $4 and a yield near 10%.
How can AMSF maintain that dividend when its EPS is less than $2.50? The EPS easily covers the quarterly dividends but not the large dividend at the end of the year.
Company management does explain in its literature that “consistent underwriting expertise and financial discipline” are reasons for its ability to return excess capital to shareholders through special dividends.
Two Ways to Do the Math
Doc may be new to dividend investing, but he’s looking for all the right things. When the numbers don’t seem to add up, it’s always worth taking a deeper dive.
There are two common, mathematical ways to look at the sustainability of a dividend. The simplest and quickest is the dividend payout ratio. This calculates the share of company earnings paid to shareholders.
The calculation gives you the percentage of earnings per share (EPS) being paid out. A good guideline for an ideal payout ratio is somewhere between 40–70%, but this is not a firm rule. If the payout ratio is too low, you’re not being paid what you should as an investor. If it’s too high, your dividend could be in danger.
A payout ratio of 100% means all the company’s earnings are being paid to shareholders. If a company’s payout ratio is above 100%, you can assume the dividend is being paid with financed money.
Another way to calculate dividend sustainability is the Dividend Coverage Ratio, also called the Free Cash Flow (FCF) method. This measures how many times a company’s free cash flow covers its dividend payments.
In this method, a higher number indicates a company’s ability to sustain its dividend payments. A ratio below 1—or even 1.5—is cause for worry. This method is trickier because FCF is not explicitly provided in a company’s filings. If you can’t find the FCF number, here’s one way to calculate it:
FCF = Net Income + Non-Cash Expenses – Change In Working Capital – CapEx
You can find these numbers on the Income Statement and the Statement of Cash Flows. Luckily, you can find these numbers on Yahoo Finance and other websites.
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So, Is the Dividend Sustainable?
AMERISAFE provides workers’ compensation insurance to small- and mid-sized employers engaged in hazardous industries. This is primarily construction, trucking, and agriculture related companies. Its earnings are based on premiums and payouts rather than selling something tangible.
The company pays four regular dividends and a special dividend. We want to look at the coverage for the full year including the special dividend, as “leftover” money from somewhere is being paid out.
Here’s the math for 2024 for AMSF. For the year, $4.48 per share were distributed to shareholders for a total of $85.436 million.
None of those numbers tell us that the dividend is sustainable. So, Doc, this was a long-winded way to say that you’re exactly correct to be concerned about AMSF’s dividend. To look at the bigger picture, you’d want to use these calculations and go back a few years.
The last year that AMSF could cover its dividend was 2019 with a payout ratio of 93.8%. Since then that number has been 102% (2020), 151% (2021), 180% (2022), 150% (2023), and 154% (2024). The improvement from 180% to 150% is meaningful, but you’d want to see further improvement in 2025.
Just as we can use a credit card to buy something we can’t afford today, a dividend can be sustained using debt. A company will do this when it wants to keep paying or increasing a dividend it can’t actually afford.
This shouldn’t be an immediate disqualifier, but it is a big red flag. It warns you that what the company is doing right now may change in the future. If the company is in a transformational period, or its management is laying out a transition plan, the company could still be a good investment.
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For more income, now and in the future,
Kelly Green
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