If one of your financial goals is to generate some passive income from dividend stocks, it behooves you to know when the companies in your portfolio are healthy, and when they're in deep danger. Likewise, when you're browsing for your next stock purchase, you'll have much better odds of finding a winner if you're using the right guidelines to separate the wheat from the chaff.
Income investors, beware: These three critical warning signs are often displayed by businesses that will soon be struggling to pay their dividends.
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1. High or rising payout ratios
The most obvious warning sign for a dividend stock is that its payout ratio is too high.
In most cases, "too high" means a payout ratio near or above 100%. Payout ratio is the percentage of a company's annual earnings that it uses to cover its dividend, so a figure above 100% is a big issue -- the business paid out more to shareholders than it generated in earnings. That's usually unsustainable. But depending on anticipated growth, ratios in the ballpark of 70% and up could be tough to maintain too.
While it's possible for an excessively high payout ratio to be a one-off occurrence after a particularly tough year or during a transitional period, investors should be particularly cautious about companies with payout ratios that have risen steadily over time.
Take a look at this chart depicting Walgreens Boots Alliance's (WBA -0.93%) payout ratio:
Data source: YCharts WBA Payout Ratio
As you can see, the situation is bad. A negative payout ratio only occurs when a company is losing money and paying out dividends at the same time. (Disbursing more than 100% of earnings requires there to be earnings to disburse in the first place.) Handing out checks to shareholders while the bottom line is in the red is an even dicier proposition than handing out unsustainably high dividends.
2. Dividend growth is slowing dramatically or has stopped altogether
When companies hike their dividend year after year for many years on end, it often reflects a degree of financial strength that portends further stability and perhaps even growth. Typically, a company's earnings need to be consistently growing to cover a steadily rising dividend, especially in the long run. But even annual dividend hikes of 1% or less still count as growth, so it's smart to look a bit deeper and consider the rate at which the payout is growing, assuming it is.
For example, over the past 10 years, Walgreens hiked its dividend by 75%, including most recently in 2022, when shareholders got a raise of 1.7%.
But look at this chart:
Data source: YCharts WBA Dividend Per Share (Annual YoY Growth)
The pattern that should jump out at you is that the company's dividend hikes have generally gotten smaller and smaller during the past 10 years. That's a red flag, and it suggests that the company is on a trajectory toward a point where it will probably cut the dividend at some point.
Nonetheless, it's important to note that not all companies have a regular dividend schedule, and many don't prioritize hiking their dividends consistently, preferring instead to hand off wads of excess cash to shareholders when it's available, and to dial back distributions when it's not. In those cases, you shouldn't judge a lack of dividend growth as harshly.
3. Management starts signaling differently
A final warning sign for dividend stocks is when management starts to discuss the dividend in a different light than in the past. Most of the time, companies that pay dividends and emphasize them as an important part of the appeal for investors make a big deal out of management's commitment to continue paying them, and perhaps even regularly hiking them. In some cases, management even offers rough guidance to investors about how much payout growth they should expect each year over a certain period.
For instance, Abbott Laboratories (ABT 0.49%) is quick to emphasize its track record of raising its dividend in all of its investor materials and earnings reports. Its streak of payout hikes is now at 51 years, making it a Dividend King. Management doesn't need to communicate much of anything for shareholders to know that more hikes are on the way. But for companies without such a long history, management will usually have a comment or two about how the dividend is a priority for capital allocation.
When a business with a history of making such promises or predictions suddenly clams up in its latest earnings report, it's a bad sign. While simply failing to reiterate its prior statements about its commitment to the dividend is not the same as indicating a cut, it's a silent message that priorities are shifting, or perhaps that past policies are no longer financially sustainable.
The same is not necessarily true for messaging surrounding other shareholder-friendly policies like share buybacks, however.
Corporate boards typically approve buybacks by earmarking large allotments of money to be spent on share repurchases over a given period. But during some periods, management may choose to use those funds for growth initiatives that they believe will deliver more value to shareholders than simply buying back stock. So don't get too spooked if the messaging about stock buybacks changes, as it could actually turn out to be good news.
