A dividend cut is like a punch to the gut if you're buying stocks for passive income. Companies can cut their dividend for a variety of reasons, but the bottom line is you're not getting that dividend check -- and the share price often takes a hit, too.
Unfortunately, you can't do anything to prevent the dividend cut when it happens, so your best defense against them is to avoid them in the first place.
Not sure what to look for? Here's what you need to know.
Why most dividend cuts happen
Dividends are cash (or stock) payments that companies use to reward shareholders and distribute their excess earnings. Most young companies don't pay dividends because it's more beneficial to shareholders that the company retains its earnings and invests them back in the business to generate growth. But a mature company with an established business model may not need all of the profits it generates.
The crucial context here is that most dividends are a cash payout: real cash leaving the company. Thus, companies cut their dividends because they no longer have the cash to support their business while also paying the dividend.
Companies fall into hardship for various reasons. Maybe management borrowed a lot of money to pursue an acquisition and saddled the balance sheet with too much debt. Perhaps the product or service they sell has fallen out of favor, and revenue begins declining. Whatever the story, businesses that aren't growing are usually fading.
Here's how to spot the warning signs:
1. Make sure profits (not debt) are paying the dividend
Shareholders love dividends as management teams are well aware. Companies can sometimes go to great lengths to cover their dividends, which isn't always in the long-term interest of shareholders. Taking out debt is common and can be a good way to raise capital if invested in ways that generate a higher return than what the debt costs.
But if a company borrows just to pay the dividend, there's no return on that money. Instead, the business now has debt and interest expenses that reduce its future earnings. Make sure the dividend is paid for with profits and not debt.
2. Check the dividend payout ratio
The dividend payout ratio is a metric that tells you how much of a company's profits go toward the dividend. The payout ratio is most commonly calculated using net income (or earnings per share), but since the dividend is a cash expense, I prefer looking at free cash flow.
Regardless of which metric you run with, you never want to see a 100% payout ratio because that means every dollar the company generates in earnings or free cash flow is paid out to shareholders, leaving little to no cushion for the business. The lower this ratio is, the better.
However, most companies can afford a payout ratio of as high as 60% to 70% before getting into trouble. And a ratio above 100% means the business pulls from its balance sheet, either its cash reserves or with debt, to pay the dividend.
3. Focus on companies that have been there before
You've probably heard the expression that past performance don't guarantee future results, but dividend stocks are somewhat of an exception. Investors should evaluate a company's dividend payout ratio and overall financial health before buying in, but there is something to be said for companies with long track records of dividend growth.
Businesses that have managed to increase their dividend for 20, 30, or 50 consecutive years have illustrated they can overcome the ups and downs of the economy, different crises throughout history, and competition -- they're battle-tested.
There are thousands of stocks, but these proven dividend growers number only in the dozens. Those new to dividend stocks would do well beginning their search in this group.
