3 Ways To Know If Your Dividend Is Safe

How can you avoid being trapped by companies that are paying dividends they can't afford?

May 26, 2014 at 8:00AM

ForSource: Flickr / danxoneil.

Very few things in the stock market are certain. Share price, earnings, market sentiment, and breaking news stories are all variables that are constantly changing on a day-to-day or month-to-month basis.

However, there is one thing that can provide a consistent return: dividends! But before you stuff your portfolio with high-yielding stocks, there are several important things to consider about companies with large dividends.

Let's compare three regional banks with nice dividends and look for possible causes for concern: Valley National Bancorp (NYSE:VLY), First Niagra Financial Group, (NASDAQ:FNFG), and TrustCo Bank Corp NY (NASDAQ:TRST).

Look

Source: Flickr / countylemonade.

Paying the bills
From a company's perspective, dividend payments are like bills the company pays to its shareholders. As long as the company is earning enough money, it has no problem paying its bills.

However, there is one major difference between a company's dividend payments and your car payment: if a company can't comfortably make its payment, it can simply cut its dividend!

So while dividend payments ideally would be something a shareholder can count on, dividends can only truly be relied on as long as the company is in a position to maintain them.

It's not always easy to predict a company's future when it comes to dividends, but there are some simple numbers that I always like to check when it comes to high-yielding stocks. First, I want to look at the current annual dividend yield of the company.

Dividendyield

With the average dividend yield of the S&P 500 currently sitting at just under 2%, these three companies' dividends are appealing to investors. But who cares about receiving a 4% dividend payment if the share price of the stock drops 20%?

So the next step in my dividend safety evaluation process is taking a quick look at how expensive the stock currently is based on the company's book value.

Pricebook

In this round of analysis, I'm looking for anything in the P/B ratios that would tell me that the stocks are overpriced.

Valley National's P/B of 1.2 is around the average for regional banks, and First Niagra's P/B of 0.6 is fairly low. TrustCo Bank's P/B of 1.7 is a little higher than I'd like to see, but it's still within the realm of reasonable numbers, so things are still looking good for these banks so far.  

The first red flag
Now that we've looked at P/B ratios, let's look at how much wiggle room these companies have when it comes to their dividend payments.

To get a snapshot of how quickly a company might be forced to cut its dividend during a downward turn in the economy, I look at a number called the payout ratio. The payout ratio is simply the dividend per share divided by the earnings per share. This number gives a quick indication of how much of a company's profits are going straight into the shareholder's pockets in the form of dividend payments. 

Payoutratio

Ideally, I like to see payout ratios under 50%, so First Niagra and TructCo pass this test.

However, Valley National's payout ratio of 88% raises the first red flag of the process. In fact, investors that were monitoring the company's high payout ratio during 2013 were probably not caught off guard by the 32% dividend cut that Valley National announced for 2014.

Since payout ratios are calculated on a trailing twelve-month basis, Valley National's 88% payout ratio includes past dividends paid before the 2014 cut. But by recalculating the payout ratio using only the past two quarters of earnings and the new lower dividend, we get an estimated current payout ratio of 59%, which is still higher than I would like to see.

It's important to understand that a high payout ratio means that any unexpected turn in the market or miscalculation in the companies' earnings projections could put them in the tough spot where their dividend "bill" is higher than their company "paycheck," and shareholders could be in for a dividend slash.

Learning from History
The final metric I like to look at when it comes to the dependability of dividends is a company's history of payments. 

Dividends

I like to see companies that have increased or maintained dividend payments over an extended period of time. Once again, Valley National fails the test, as the company decreased its annual dividend by nearly 8% from 2011 to 2013. First Niagra also fails the test, as it cut its dividend in half between 2011 and 2012. TrustCo's dividend history demonstrates the kind of consistency and dependability that I like to see from a company.

The results are in!
There is no question that the dividends that these three companies pay could be a nice source of income for shareholders. However, the high payout ratio of Valley National and its history of dividend cuts should make investors very leery.

First Niagra's current payout ratio is reasonable, and its book value suggests the stock is currently under-priced. However, the 50% dividend cut stands out like a big black eye on the company's payment history.

Despite its relatively high P/B, TrustCo Bank, which has consistently paid the same dividend over the past three years while maintaining a reasonable payout ratio, would be my pick for the safest dividend of the three.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Wayne Duggan is the author of Beating Wall Street with Common Sense and the developer of tradingcommonsense.com. Wayne Duggan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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