A high-dividend stock isn't such a great investment if its payout isn't sustainable. Here are two big red flags to look out for that can indicate a dividend may not last forever.
A full transcript follows the video.
This video was recorded on April 30, 2018.
Michael Douglass: The second one, as you talked about earlier, Matt, is excessive debt.
Matt Frankel: Yeah. The general idea is, the more debt a company has, the more likely it is to run into trouble when things don't go its way. There's an old saying that a company with no debt can never go bankrupt. Not entirely accurate, but it's pretty effective. The way I like to look at this is, look at a company's debt-to-equity ratio, which, you can easily find both of those numbers right on its balance sheet, outstanding debt and shareholders' equity. And, compare that not just with itself to see if it seems like it has a high level of debt, but compare it with the dividend yield with other companies in its industry to see if something seems out of whack. Telecom companies like AT&T and Verizon tend to take on more debt than tech companies, which tend to have very little debt, for the most part.
Douglass: Right. REITs tend to take on a lot more debt than, say, restaurants.
Frankel: Right. This is not an apples-to-apples comparison. Just because a company has, say, higher than a 1:1 debt-to-equity ratio doesn't necessarily mean that it's a big red flag. But, if a company has a debt-to-equity ratio of, say, 3:1 and the rest of the companies in its sector are in the 1:2 range, then it might be a cause for alarm.
Douglass: Right. Keep in mind, as well, we're in financials. This is a pretty levered area in general. Banks, REITs, a lot of these companies do tend to take on a fair amount of debt. So, that nuance is really important. Just because there's a fair amount of debt, doesn't necessarily mean anything bad if that's how things operate. Again, it's all about that nuance and that story.
No. 3: payout ratio.
Frankel: Right. There's a couple of ways you can calculate this, depending on what sector you're talking about. Payout ratio, in its simplest form, is just the ratio of a company's dividends paid per year to its earnings per year. So, if a company paid out $0.50 in dividends last year and earned $1.00 per share, its payout ratio would be 50%.
Payout ratios above 100% are particularly alarming. The one area where that wouldn't apply to is REITs, companies that have to pay out a lot of their earnings and have a lot of accounting things like depreciation that distort what they're actually making. In REITs case, actually, a lot of times, you'll see REITs with payout ratios just based on earnings of well over 100%. And not only is it OK, it's actually very sustainable, in some cases. With REITs, you want to use a metric called funds from operations or FFO for short. That's the REIT version of earnings that takes into account depreciation and things like that.
Douglass: Right. One of the other pieces is, sometimes a company buys another company. We've all probably been watching enough news to see that happening. And as a result, their earnings will be materially affected for a year. So, that payout ratio might spike well above earnings for a year. But, that was something that, in all likelihood, they planned for, they had some cash set aside for it, they didn't want to interrupt the dividend that year. But, in that case, it's useful to look back a couple of years and say, "OK, before company A bought company B, this one-year thing, what was the payout ratio?"
One of the other ways to look at payout ratio, by the way, is the cash dividend payout ratio, which is to look at operating cash flow minus capital expenses and compare that to the dividend payout. So, if they're paying out $0.50 per share in cash, and they have free cash flow of $1.00, then that's a 50% cash dividend payout ratio.
Frankel: Right. Earnings can be deceiving, is the takeaway there. Especially, like you said, in the case where one company buys another company. There are all kinds of accounting rules that are way too complex to get into in a 30-minute podcast that can really distort a company's earnings and make a dividend look too high when it's really not, or make a dividend look sustainable when it's really not. So, it's important to take a few different things into account, cash flow being one of them. If a company is bringing in more money than it's paying out, you might be OK.
Matthew Frankel owns shares of AT&T. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool has a disclosure policy.