If you want to gain an edge on other dividend investors, there's one very simple tip you need to know. It's just basic common sense, but way too many investors overlook it because they get caught up focusing on a company's story instead of the facts on the ground -- and in the end, you make the mistake of buying a high-yield dividend stock that ends up cutting its dividend.
I'm not going to keep you in suspense; what you need to do is check the balance sheet. Here's why it's so important, and a couple of ways to spot when a company can't afford its dividend.
Financial strength always matters
A company can be thought of as a living organism that will almost always be looking to ensure its own survival. You may be a partial owner of the business, but that won't matter when the chips are down. The company is going to do what it needs to do to remain a going concern. Don't dismiss this -- it's very important for dividend investors to remember when looking at high-yield stocks.
There are a lot of things that happen when a company is facing headwinds. Usually its stock will fall, pushing the dividend up. This can be a great time to buy a company, and often leads to stocks showing up on value investing screens. But it can also lead you into a dividend trap, meaning you'll be acquiring a business that can't sustain its dividend over the long term. If the dividend gets cut in an effort to preserve cash, the income you were hoping to collect from your high-yield investment won't materialize. Worse, the stock could end up falling even further (investors hate dividend cuts). The difference between a dividend that survives and one that gets trimmed (or eliminated) is often the company's financial foundation, which you can discern with a look at its balance sheet.
The good news is that you don't need to be an accountant to understand what's going on. The signs of financial stress are fairly easy to see once you know what to look for. This isn't foolproof, of course; there are situations outside of the norm that can sideswipe even a financially strong company and lead to dividend cuts (COVID-19 is an example). But on the whole, if you can separate the financially strong from the weak, you'll be much better off in the long run and feel much more confident in buying an out of favor, high-yield name.
Some quick and dirty facts
The first thing to consider is simply the amount of debt a company is carrying. The absolute number, however, isn't the right metric to look at. You need to look at debt on a relative basis. The first thing to look at is debt relative to the company's own business, which is probably best communicated by its financial debt to equity ratio. financial debt to equity is the liabilities on the balance sheet that are non-operational (long term debt and long term debt due in one year) over a company's total equity (market capitalization plus preferred stock). If you want to be more stringent, debt to equity (all outstanding debts divided by the equity value on the balance sheet).
You can do the math yourself, or you can simply use an online tool to look these ratios up. The higher these ratios are, the more leverage there is. Lower is better.
But don't stop there, because some businesses and industries can support high levels of leverage. You want to consider leverage relative to the company's own history and to its direct peers. If leverage is out of line with either of those, you may want to take a pass. A good example of this is Kinder Morgan (NYSE:KMI), which was facing industry headwinds in late 2015 and early 2016. It had a history of using more leverage than its peers, like industry bellwether Enterprise Products Partners, and its leverage was ticking higher than its own historical trends. The pipeline giant made the tough call to cut the dividend and use the freed-up cash to invest in growth projects at a time when it couldn't easily tap the capital markets for the money it needed. It was the right move for Kinder Morgan, but it was a tough hit for income investors.
It should be intuitively easy to understand that a heavy reliance on leverage simply limits a company's options -- it's exactly the same situation you would be in if you had a massive mortgage payment to make each month. But there's another important number on the balance sheet that you should consider: cash. When times get tough, cash is king. If there's too little cash floating around, a company will have to take drastic steps to improve its liquidity so it can pay its bills. Cutting the dividend is a quick and easy way to retain more cash.
Once again, the absolute number isn't that helpful. However, if cash has been consistently falling you should probably be concerned. Another way to examine cash, however, is with the current ratio, which compares cash and other assets that could be quickly turned into cash to current liabilities (effectively a company's near-term bills). And if you want to take an even more stringent view, look at the cash ratio, which only considers actual cash in relation to current liabilities.
Nielsen Holdings (NYSE:NLSN) provides an example here. As the chart above shows, the company's current and cash ratios started to decline before the dividend got cut. To be fair, there's a lot more to the story, notably including business-specific troubles, but the decline in cash was a key part of a bigger problem that led up to the cut.
The current ratio and the cash ratio are a bit harder to use because some financially strong companies have business models that don't require carrying a lot of cash (food manufacturers are an example of this). So once again, the key is to look at trends and, perhaps more important, compare the cash balance to the business environment in which the company is operating. If a company is struggling through a rough patch and cash is tight, you might find the dividend ends up getting cut.
A quick check
It's pretty simple: If you are looking at a high-yield stock you need to make sure it has a strong enough financial foundation to keep paying. Checking the balance sheet to assess a company's leverage and cash position is an easy way to get a handle on that. A fat yield with too much leverage and minimal cash could end up costing you a lot more than you bargained for. There are other tools to look at when it comes to dividends, of course, but very often a simple look at this one financial statement will be all you need to do.
When it comes to dividends, erring on the side of caution is usually the best option. Avoiding the most obvious mistakes, meanwhile, will lead to thousands of extra dollars in your pocket over the long term.