If you find the right dividend-paying stock, it can make you rich. Choose wrong in a tough economic environment like this one, though, and you could end up not only seeing an established dividend get cut, but also suffering a big loss as a result.
It's no secret that plenty of companies have been cutting dividends lately. Even well-established dividend payer Dow Chemical (NYSE: DOW ) , which sported a track record of 97 years without a dividend cut, had to reduce its dividend in response to the contracting economy. Especially within the financial realm, many banks have reduced or eliminated dividends to conserve capital.
However, you don't have to get blindsided by weakening companies. If you look closely, you can find warning signs of potential trouble before a company bites the bullet and announces a dividend cut. Although some companies may recover before circumstances become so dire that they have no choice but to cut dividends, you're better off safe than sorry in a bear market.
Look for the cash
Obviously, if a company isn't earning a profit, it's difficult for it to pay dividends. Sometimes, a company can borrow money to cover a dividend payment. But with the current credit crunch, money-losing companies can't afford to leverage their balance sheet just to pay shareholders.
That's why many investors look at the payout ratio as a sign of a healthy dividend policy. If a company isn't earning enough to cover its dividends, that's a sure sign that its dividend level isn't sustainable in the long run. On the other hand, if earnings exceed dividend payouts by a fair margin, shareholders can expect dividends to continue.
The problem with using payout ratios based on earnings, however, is that thanks to GAAP accounting methods, earnings don't necessarily translate into cold, hard cash that a company can use to pay a dividend. So in order to pick up actual cash, some analysts like to use payout ratios based on free cash flow. And in an environment where making debt repayments can eat up valuable cash, using levered free cash flow -- which takes those repayments into account -- really pins down how much money companies can afford to spend on dividends.
Dangerously high payouts
Looking at the levered free cash flow payout ratio, you can identify stocks that are showing warning signs of cash shortages. Here, for instance, are five companies with particularly high ratios recently:
|
Stock
|
Dividend Yield
|
Earnings Payout Ratio
|
Levered FCF Payout Ratio
|
|
Nordstrom (NYSE: JWN )
|
5.3%
|
26%
|
947%
|
|
PPL (NYSE: PPL )
|
4.5%
|
65%
|
496%
|
|
Tiffany (NYSE: TIF )
|
3.4%
|
27%
|
429%
|
|
Microchip Technology (Nasdaq: MCHP )
|
7.0%
|
83%
|
145%
|
|
Yum! Brands (NYSE: YUM )
|
2.6%
|
35%
|
145%
|
|
Centerpoint Energy (NYSE: CNP )
|
6.2%
|
52%
|
121%
|
Sources: DividendInvestor.com; Capital IQ, a division of Standard and Poor's.
The numbers show the disparity between payout ratios based on earnings and levered free cash flow. If you'd only looked at earnings, you might have concluded that there was no danger whatsoever to dividends for several of these stocks. Yet a closer look at actual cash flow, along with the debt some of these companies have, paints a bleaker picture.
On the brighter side
One thing to remember, however, is that these high payout ratios based on levered free cash flow haven't always led to falling dividends in the past. Tiffany, for instance, has had a history of volatile levered free cash flow -- yet it has raised dividends consistently for years. Nordstrom had a big negative levered free cash flow number in its 2007-08 year, but it still pushed its dividend higher by nearly 20% in 2008.
Nevertheless, keeping both sets of payout ratios in mind is a prudent move for dividend investors. When companies repeatedly hike dividends over the years, even holding a dividend flat can cause a stir among investors -- and a cut can be devastating. And when a company's financials start squeezing its ability to meet all of its cash obligations, that's when you need to be most on your guard.
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