When buying dividend stocks, the safety of the dividend is even more important than the payout amount. After all, what's the point of investing to create an income stream if that income can vanish at any time?
With that in mind, there are both good signs and red flags you should look for when evaluating a dividend stock. Here are some ways to tell whether a dividend is sustainable and likely to grow in the future.
The payout ratio: The No. 1 dividend indicator
When assessing whether or not a dividend is sustainable and healthy, the company's payout ratio is the best place to start.
Basically, the payout ratio is the company's dividend divided by its earnings. So, if a company earned $5 per share and paid $2 in dividends to shareholders, its payout ratio is 40%.
You may see this ratio calculated using TTM earnings or forward earnings, and I prefer to use the latter. When using TTM earnings, you are assessing whether or not the company's dividend was healthy last year. By using forward earnings projections, you can determine whether or not it is sustainable.
As an example, consider Transocean (NYSE:RIG), a leading manufacturer of drilling rigs for the oil industry. The company currently pays annual dividends of $3 per share, and given that it's expected to announce 2014 earnings of $4.78, the dividend may look healthy and sustainable. However, because of the massive drop in the price of oil, 2015 earnings are expected to drop to $2.40. This would create a payout ratio of 125%, which means the company won't earn enough money to cover the current dividend, and a cut is likely.
I like to buy dividend stocks with a forward payout ratio of 50% or less, which leaves more than enough room to absorb a hit to earnings and to grow the dividend in the future.
The past tends to repeat itself (with dividends, that is)
Although an investment's past performance doesn't guarantee future results, there are some trends that tend to develop.
There is a group of stocks called the Dividend Aristocrats that have all raised their dividends for at least 25 consecutive years. Many of these stocks deliver better long-term performance than the S&P 500. For example, Johnson & Johnson (NYSE:JNJ) has increased its dividend for 52 consecutive years and has raised its payout by an average of 9.8% per year, all while delivering average annual total returns of 13.3%.
The stocks you choose don't necessarily need to have a Dividend Aristocrat-like record, but a solid history of dividend growth is a good indicator of a safe dividend investment. On the other hand, a history of inconsistent dividends should be a major red flag.
Exceptions to the rules
There are some exceptions to these rules. Some companies can maintain a very high payout ratio while still being strong and safe dividend investments.
For example, real estate investment trusts, or REITs, are required to pay out at least 90% of their income to shareholders. So if you see a REIT with a payout ratio of 95%, it's not a bad sign at all. In fact, some REITs have payout ratios slightly above 100% and yet are still healthy and sound investments.
If it sounds too good to be true...
Finally, beware of dividends that are exceptionally high. This can be a red flag for one of two reasons.
First, a dividend may be very high because it's likely to be cut in the near future. This is the case with Transocean, which yields about 19% as of this writing. Because earnings are expected to drop sharply this year, it should be no surprise if the dividend does the same.
A dividend may also be sky-high because the underlying business is risky and unstable. For example, mortgage REITs like Annaly Capital Management (NYSE:NLY) can produce double-digit dividend yields because they borrow money at high ratios. Unfortunately, this leaves them susceptible to interest rate fluctuations, so their dividends are unstable.
To sum it up, an unusually high yield, or one that represents a high percentage of a company's earnings, should be a big red flag. However, a reasonable payout ratio and a solid track record are the makings of an excellent dividend investment.
Matthew Frankel owns shares of Transocean. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.