You'll hear it again and again from seasoned long-term investors: Buy and hold dividend stocks, and reinvest the distributions to maximize your long-term returns through the power of compound growth. That's a tried-and-true formula for success, but eager investors may be tempted to juice their returns by attempting it with stocks that have unusually high dividend yields.
But problematic things can happen with some of these ultra-high-yield stocks. If a company's dividend is unsustainable, management might cut its payout or even eliminate its dividend entirely. If that happens, you could end up owning shares of a fast-falling stock representing a business in decline.
Therefore, it's worth the time and effort to check these metrics for possible trouble before diving headfirst into an enticing high-yield stock. If the red flags are flapping, you'd probably be better off opting for a stock with a less flashy but more sustainable yield.
1. Is the payout ratio healthy?
It's no secret a company's payout ratio can provide a handy gauge of its dividend's sustainability. It's quite a popular metric for income investors to use, likely because it's both easy to calculate and easy to understand.
Take the company's total annual dividend payout (the dollar amount, not the percentage yield) and divide it by the company's earnings. You can use the company's trailing-12-month (TTM) earnings or its forward earnings estimate to calculate this number. However, if you prefer to use hard, known data instead of future forecasts and predictions, stick to the TTM figures.
As a general rule of thumb, a company's dividend payout ratio should be below 50%. So, for example, if a company paid out $25 million in dividends over the past year and earned $100 million during that time, that would give it a quite reasonable payout ratio of 25%.
While the payout ratio can be a helpful metric, it's not a universally applicable touchstone. For example, REITs and MLPs are required to pay out 90% of their income as dividends. As a result, the payout ratio is just one tool you should supplement with additional details like the ones below.
2. How consistent is its payout history?
If a company doesn't have a payout ratio that's at a satisfactory level, review its history of dividend payments next. Ideally, it will have a long track record of consistent payouts -- ideally measured in decades rather than years. After all, even a business offering an unusually high dividend yield can ease investors' concerns by building up trust with shareholders over time.
Better yet, the company may even increase its dividend payments (the dollar amount, not the percentage yield) at least once a year. A stellar example is Lancaster Colony, a food producer that has raised its distributions for 59 consecutive years. Not every company you buy as an income investment has to have such a rock-solid track record, but it's still important to check the consistent-payouts box before hitting the "buy" button.
3. How strong is its cash flow?
Remember, a dividend is only safe as long as the company has the cash -- or at least, the access to cash -- to keep making the payments. With that in mind, here's another formula that's almost as simple as the payout ratio.
Divide the company's total dividend payments by its free cash flow. To get the free cash flow figure, start with the company's net cash from operating activities and subtract its capital expenditures.
These items can all be found in any company's quarterly or annual financial filings. Naturally, if you're going to invest in a company, you'll want its free cash flow to be higher than the dividends it pays out. To really feel confident about a dividend being sustainable by this metric, you won't want the payouts to exceed 70% of the company's free cash flow.
When a company starts going higher than 70%, it's getting into dangerous territory where it might have to start borrowing money to maintain its dividend. Otherwise, management might end up cutting its payouts, which would run counter to the previous guideline that solid dividend payers should raise their distributions, not cut them.
