Whether the goal is to generate income, supplement total return, or cushion the blow of a falling market, most investors can benefit from holding dividend-paying stocks. Value Line offers a collection of articles discussing the merits of dividends. For instance, Yielding To the Allure of Dividends provides an excellent primer to get started. Additionally, Dividend Yield vs. Dividend Growth explores the tradeoff between a high, yet steady payment, and the prospects for an increasing disbursement.
Investors have quite a few options regarding companies that pay dividends. Traditionally electric utilities and real estate investment trusts (REITs) offer generous payments. Read Investing in Electric Utility Stocks and REIT Stocks: Still the Ultimate Cash Flow Machines for the basics on these industries. Moreover, mature companies such as, McDonald’s Corporation (MCD - Free McDonald's Stock Report), Clorox Company (CLX), and Johnson & Johnson (JNJ - Free Johnson & Johnson Stock Report) typically pay out worthwhile compensation in return for holding their shares. Furthermore, the weekly Value Line Selection & Opinion section regularly features stock screens focused on dividend-paying equities.
Dividends are not guaranteed, and ultimately depend on the board of directors’ approval. That said, companies have gone to extreme lengths in the past to avoid cutting their payments. However, sometimes dire circumstances may not offer any alternative. For example, even though the payouts of high-yielding bank stocks like JPMorgan Chase & Company (JPM - Free JPMorgan Stock Report) and Bank of America (BAC - Free Bank of America Stock Report) were once considered safe, the payments were slashed 65% and 92%, respectively, during the financial crisis. Therefore, before purchasing a stock for its dividend, investors should review a few metrics to assess dividend safety.
Dividend Payout Ratio
The dividend payout ratio can be found on the Value Line Page at the bottom of the statistical array under “All Div’ds to Net Profit”. Value Line, like most, calculates the dividend payout ratio as “all dividends declared” divided by “net profit”, which represents the amount of profit paid out to shareholders. A healthy range for large mature companies is between 40%-60%. However, companies have unique capital requirements and operating conditions, so the payout ratio should be compared against industry peers.
For a company with a high payout ratio, a small decline in earnings might cause net profits to fall short of the required dividend payment. To cover the outlay, the company could dip into its coffers, take out a loan, and/or issue securities. Although companies may occasionally pay an uncovered dividend, the practice usually doesn’t last long. More often than not, an uncovered dividend payment will be reduced.
Looking at “All Div’ds to Net Profit” in Bank of America’s statistical array, the payout ratio jumped above its historical norm of about 45% to 73% in 2007. The company continued to pay a quarterly dividend of $0.64 until the fourth quarter of 2008, when it cut the payment in half, to $0.32. The above-average payout ratio, combined with a weakening operating environment, suggested a dividend reduction was likely.
Dividend Coverage Ratio
On the other hand, the reciprocal of the dividend payout ratio produces the Dividend Coverage Ratio. The coverage ratio, which is not featured on the Value Line Page, but easily computable by using the reciprocal button on a calculator or dividing 1 by the dividend payout ratio, indicates the number of times that earnings can pay the dividend at current levels. Barring any nonrecurring events or extraordinary circumstances responsible for a temporary earnings decline, a dividend coverage ratio approaching 1 or lower indicates the payment may be in danger.
As one example, Southern Copper Corporation (SCCO), a leading raw-materials producer, averaged a dividend coverage ratio of nearly 2.4 over the 2000-2005 period. During the three years from 2006 to 2008, the coverage ratio deteriorated to 0.82. The following year, the company reduced the dividend by approximately 77%.
Qualitative measures of dividend safety do not hold much water by themselves, but prove quite valuable when used in conjunction with other metrics. Stable or increasing dividend payments over time are a boon. Conversely, a history of reductions or declining dividends is a drawback. Concerning dividend quality, Benjamin Graham once advised: “the absence of rate reduction in the past record is perhaps as important as the presence of numerous rate advances.” The diversified telecom giant, Verizon Communications (VZ - Free Verizon Stock Report), boasts an unblemished track record including steady payout increases and no dividend cuts.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.