More than 340 companies reduced or eliminated their dividends in 2008. Whether you rely on your dividends for current income, cash to reinvest, or signals of a company's true strength, those reductions should be troubling.
Yet even amid all the chaos and panic of 2008, not all the dividend news was bad. Many companies managed to maintain their payments throughout 2008, and some even raised them.
Last year might have been one of the most extreme investing years of recent memory, but even in more usual markets, being able to tell the difference between a strong, well-supported dividend and one on the verge of elimination might be the most important skill you carry in your investing toolkit.
3 ways to tell
Three metrics can help you eyeball a dividend's sustainability.
First, a company's payout ratio (the percentage of earnings paid out to investors through dividends, calculated as the yearly dividend per share divided by the earnings per share), has historically provided an excellent indicator of the dividend's sustainability. So long as a company didn't pay out too much of its earnings, the dividends were likely safe.
While that's still an important metric, the credit crunch that led to this particular meltdown serves as a stark reminder that there's more to financing dividends than simply earning a profit.
Second, a company's quick ratio (a measure of short-term liquidity) helps you see how well it can cover the bills it has coming due based only on its cash on hand and easily liquidated current assets.
In an economy like this one, when even profitable companies can't easily refinance their debts, a strong quick ratio will help protect those payments. General Growth Properties (NYSE: GGP ) , for example, was forced to suspend its dividend because of an inability to pay, extend, or roll over its debt, despite being cash flow positive.
Finally, a company's debt-to-equity ratio, which divides total liabilities by the shareholder's equity, demonstrates just how much debt it has taken on relative to its unencumbered assets.
Too much debt can hurt dividends in two ways. First, the lenders get payment priority over the shareholders. If a company runs into a cash crunch, its dividends will be among the first things to go. That's why automakers like Ford (NYSE: F ) cut their payments back when their businesses started deteriorating a couple years back. Shareholders might complain, but unpaid debtholders can take over a company.
In addition, when that debt matures, it will either need to be rolled over into new debt or paid in full. If a company can't borrow to pay off its maturing debt and can't pay it off with cash on hand, even a profitable business can be forced into bankruptcy.
Can you separate the best from the rest?
While 2008's numerous dividend implosions serve as reminders that dividends are never guaranteed payments, companies with strong financials are far less likely to have to slash theirs.
Some good rules of thumb to consider:
- A payout ratio less than 67% shows both that the company is profitable, and that it has the temperament to put some of those profits away for a rainy day.
- A quick ratio greater than 1.0 means the company has the ability to cover all the debt that's coming due within a year.
- A debt-to-equity ratio less than 2.0 reduces the odds that the company will either be overwhelmed by interest payments or run into a financing crunch when its debt matures.
Here are a handful of firms that pass those tests today:
|
Company
|
Payout Ratio
|
Quick Ratio
|
Debt to Equity Ratio
|
Dividend Yield
|
|
Qualcomm (Nasdaq: QCOM )
|
31.1%
|
4.6
|
0.8%
|
1.8%
|
|
Robert Half International (NYSE: RHI )
|
23.5%
|
2.1
|
0.4%
|
2.5%
|
|
Tootsie Roll (NYSE: TR )
|
42.2%
|
2.0
|
1.2%
|
1.4%
|
|
Administaff (NYSE: ASF )
|
24.4%
|
1.1
|
0.3%
|
2.6%
|
|
American Ecology (Nasdaq: ECOL )
|
54.5%
|
2.7
|
0.0%
|
3.6%
|
While the sustainability of a firm's dividend isn't the only reason you would pull the trigger on its stock, it's one sign that a company deserves a further look.
It's time to buy quality
Research by Wharton professor Jeremy Siegel demonstrates that reinvested dividends are key to strong long-term returns -- and that means finding dividend stocks you can count on. Starting with the three metrics outlined above, and following them up with in-depth research into the company's balance sheet, competitive advantage, and management, will help you find stocks for the long haul.
At Motley Fool Income Investor, our goal is to help investors build a portfolio of companies that pay strong, reliable dividends. By paying attention to the fundamentals behind the businesses we select, we've managed to help our members both keep steady income streams and stay ahead of this tumultuous market. If you're ready to escape from the chaos that this market has brought with it, and focus your investments on companies with staying and paying power, just click here for a free 30-day trial. There's no obligation to subscribe.
At the time of publication, Fool contributor Chuck Saletta did not directly own shares of any company mentioned in this article, but his wife owned shares of General Growth Properties. Administaff is a Motley Fool Hidden Gems Pay Dirt pick, as well as an Inside Value recommendation. The Fool has a disclosure policy.
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