Dividend Safety In Volatile Times

We are going to need our seatbelts fastened to ride out the volatility through the rest of the year. The CNN Fear & Greed Index is in extreme fear. It’s gotten so bad that yesterday all seven sub-indicators had dropped into extreme fear.

The fear is here and, unfortunately, it’s not irrational.

It’s a good time to be collecting dividends while the markets move around. I plan on holding the wealth builders in my portfolio for years or even decades. That’s because I believe in the strength of dividends through whatever the market throws our way. If share prices fall in the short term, a strong company will prevail in the long term.

This only works if the dividend does, in fact, remain sustainable. With all the volatility right now, it’s a good time to review how you can know if a dividend is actually secure.

Check the Pay Out Ratio

There are really only three things a company can do with its profits: save it for a rainy day, reinvest it back into the business, or pay it out to shareholders as a dividend.

To know whether or not a dividend is sustainable, we need to know what share of company profits are used to cover the dividend.

There are two common ways to calculate this.

The simplest and quickest way is the dividend payout ratio. You will almost always find this number when you look at financial statistics on a stock. Schwab shows it in the dividend section if you click “show more.”

Here’s the math:

This calculates the percentage of earnings per share (EPS) being paid to shareholders. The remaining portion can be reinvested or saved.

A low payout ratio could mean you’re not being compensated fairly as an investor. It could also just be that a company must reinvest heavily into its business—think of a tech company that needs to stay ahead of its competitors.

If the payout ratio is too high, your dividend could be in danger. A payout ratio of 100% means all the company’s earnings are used to pay the dividend. There would be nothing available to invest in the business.

If the payout ratio is above 100%, you can assume the dividend is being paid with financed money. This might make sense temporarily if the company is in a transformational period, but it is not sustainable long term.

Although not a firm rule, an ideal payout ratio is between 40% and 70%.

The FCF Method

Many dividend investors like to use the free cash dividend coverage method. The payout ratio method uses earnings-based numbers that can be distorted with things like depreciation and amortization or one-time charges. Free cash flow is actual cash in the door.

Once again, the math:

In this method, we’re looking at how much coverage the dividend has, so a higher number indicates more sustainability. Here are some guidelines:

• 2x or above is considered a comfortable cushion

• 1.5x to 2x is well covered

• 1x to 1.5x is manageable but worth monitoring

• Below 1x should be considered a red flag

Once it gets below 1x, we should assume the dividends are being paid with credit. Again, that is not sustainable long term.

This method is trickier to use because free cash flow (FCF) is not a line item in GAAP financial statements. Some companies will disclose it in their earnings release, but you might need to calculate it. Here’s the math:

FCF = Net Income + Non-cash Expenses – Change in Working Capital – CapEx

These numbers are all available on the Income Statement and Statement of Cash Flows.

Remember that the payout and coverage ratios are a snapshot of a particular period, typically a quarter. You can put these dividend sustainability metrics in perspective by calculating them over a few consecutive quarters or years.

If the payout ratio is trending higher year after year, you definitely have a problem. If it spikes up for a quarter, it might be an anomaly and not a signal that there is a long-term problem.

At the end of the day, now is the time to have dividend payers in your portfolio. We just have to make sure those dividends will weather the inevitable volatility.

For more income, now and in the future,

Kelly Green