A high dividend yield can be a sign of a strong, stable company and investment. However a large dividend yield may also be a signal of trouble and a hint that the company’s dividend may be unsustainable and cut in the near future.
Thankfully for investors, there are several quick checks you can do based on a company’s financial statements to see how sustainable that dividend really is.
Why Do Investors Like Dividends?
Today’s low interest rate environment makes it difficult for investors to be able to safely receive enough income from their investments to retire comfortably. Consider a retired investor with $1 million:
10 years ago a $1 million portfolio consisting of only 10 year U.S. Treasury bonds would provide an investor with a nearly risk free $45,000 (4.5%) in income per year. Today, that million dollars would barely provide $24,000 (2.4%) – more than likely not enough income for retirement.
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For that reason investors are increasingly chasing dividend paying stocks in a search for increased yield. The problem is that in search of high yield investors are buying more and more low quality company stocks, exposing their investments to more and more risk.
How can investors ensure that their investments are safe? There are a couple of easy, basic calculations that investors can use to determine the sustainability of a company’s dividend.
How To Determine if a Dividend is Safe
First, and most basic is known as the company’s Dividend Payout Ratio:
A company’s dividend payout ratio tells investors how much (as a percentage) of a company’s profits are paid out to investors in dividends. A low percentage tells investors that the company has plenty of room to pay the dividend and possibly raise it in the future. A higher percentage tells investors that the company can barely pay the dividend, and without business improving would likely not be able to afford a dividend hike.
100% means that all of the company’s profits are paid out in the form of dividends.
The dividend payout ratio can be calculated from the company’s annual dividend per share and the company’s annual earnings per share (EPS), or by dividing the company’s total dividends paid by the company’s net income.
This information can be found a couple of places in the company’s most recent 10k financial filing. For this post, we will be using Intel’s 2011 10-k financial report as an example. All of Intel’s financial statements can be found on their website or on the SEC’s EDGAR database – found here:
To calculate Intel’s 2011 dividend payout ratio, we take the annual dividends paid per share ($0.7824) and divide that by Intel’s basic EPS ($2.46).
Or 31.8%, meaning 31.8% of Intel’s profits are returned directly to shareholders in the form of dividends.
Calculating the payout ratio the second way, Total dividends paid divided by net income:
Total dividends paid can be found on Intel’s Statement of Cash Flows:
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Or total dividends paid can be calculated by multiplying the basic number of shares outstanding (found above and on Intel’s Statement of Income), which is 5.256 billion by the dividend paid per share ($0.7824).
Or 31.77%, pretty much 31.8% as we found with the other calculation.
Note, previously when making calculations based on the number of shares outstanding, we have stated that you want to use the diluted number of shares outstanding to take into account future dilution. However, for this we are using basic number of shares outstanding. This is because the company did not actually pay dividends to the extra shares included in the diluted share count.
Remember, the diluted number of shares are the shares that would be outstanding if all stock options and warrants are cashed in. Some of the shares do not actually “exist” yet, but may be created when stock options are cashed in.
It could be a good comparison to calculate the dividend payout ratio based on the diluted number of shares as well. This may clue investors in of potential trouble down the road if all those stock options are taken.
And here we use the diluted EPS, $2.39 per share, as noted on the income statement.
For Intel, the difference is minimal, which is a good sign for investors. Even if all outstanding stock options and warrants are cashed in, Intel will still be able to continue paying the dividend.
While researching other stocks, be very cautious if you find very large differences in diluted numbers and basic numbers. This may be a sign of a company whose dividend would be at risk when or if executives cash in their stock options.
For an example of a “dividend trap”, that is a stock that currently offers a high dividend but is unsustainable – and which investors should be very cautious of. Consider Frontier Communications (Ticker FTR). Currently many investors are investing in FTR solely because of its dividend yield.
9.5% dividend yield seems very nice, but is it sustainable? If FTR announced a dividend cut, how do you think investors would react? More than likely your investment would take a large hit, making the one or two dividend payments you might received obsolete.
Look at FTR’s last 9 months of business:
$124 million in income….
But it has paid nearly $300 million in dividends!
This is not sustainable, and investors should not be surprised if the dividend is cut.
Business may turn around, but even if Frontier’s income doubles, it still will not be able to pay its dividend without using cash reserves, taking out a loan or selling assets.
This is just one example. Before investing in a stock because of its dividend, check to make sure the company can at least afford to pay the dividend.
Another way to calculate a company’s ability to sustain a dividend is by comparing the dividend with the company’s Free Cash Flow.
Use Free Cash Flow To Determine if a Dividend is Sustainable
Free Cash flow is the money a company has left over after it pays the expenses required to run its business. Free cash flow is used for research and development, build cash reserves, pay back debt, update equipment and pay dividends.
We have discussed previously how a company may be able to show decent EPS (Earnings Per Share) with accounting tricks, but really not be generating any cash. For this reason, many analysts prefer using the cash flow statement over the income report for their research and analysis. By comparing dividends to free cash flow instead of profits, investors get a much more conservative view of the company’s ability to pay dividends. If a company has to repeatedly tap into its cash reserves in order to fulfill dividend payments to shareholders, it may be a sign that the dividends are unsustainable.
For this comparison I am going to look at the percentage of the company’s free cash flow used to pay dividends. A smaller percentage means the company will have plenty of room to pay or increase dividends in the future (if business and margins stays stable). A high percentage means the company has much less room to pay or raise dividends.
First, defining Free Cash Flow (FCF):
Operating Cash Flow is the cash brought in from the sales of the company’s products and is listed on the company’s Statement of Cash Flows.
Capital Expenditures (CAPEX) are expenses to acquire, update or repair physical (also known as tangible) assets. Most commonly referred to as Property, Plant and Equipment (PPE).
Intel’s CAPEX is listed a few lines below Operating Cash Flow on the Statement of Cash Flows.
After subtracting Intel’s CAPEX from its operational cash flow, we find Intel’s free cash flow to be:
Or, about $10.2 billion.
Now lets compare this to the total amount of dividends paid out by Intel, which we found earlier to be about $4.127 billion (as listed on the company’s statement of cash flows).
Intel is paying 40.4% of its free cash flow back to shareholders in the form of dividends.
A value of over 1.0, or 100% means that the company did not generate enough cash through normal business operations to pay the dividend. It means the company either had to raise cash from financing (taking out a loan), liquidate assets or use its cash reserves to pay the dividend.
It is important to note that a company’s free cash flow can vary widely from year to year, and a negative free cash flow once in a while is not necessarily a bad thing. If the company makes a large one time investment, it will impact the company’s reported free cash flow significantly and the company may have to use some of its cash reserves to pay its dividend. But that large one time investment may be increased returns for years to come. However, if year after year a company has a negative free cash flow and is borrowing or using cash reserves to pay its dividend, it may be a sign of trouble.
So investors looking to compare a company’s dividends with its free cash flow should look at multiple years of historical data and consider the size of the company’s cash reserves to be sure one time events are not causing you to overlook an investment opportunity.
Update with GE Dividend Cut
Big news this morning as General Electric (GE) cut its dividend for only the third time since 1899. Were there warning signs? You bet!
Here is what I had to say a few months ago to a friend, along with some numbers at the time:
But GE’s current dividend is still based on those earnings from GE Capital, and unless the industrial side of GE starts to pick up, it is going to be hard for GE to keep up its dividend. For example, at GE’s current dividend ($0.24 per share, per quarter) it has paid $4.2 billion to shareholders in dividends so far this year, but the industrial side of GE only generated $3.6 billion in cash over that same period. You can see GE has added on debt recently to help maintain its dividend (among other expenses), which is fine if it is just weathering a storm. But I don’t know enough about the business to place a large bet that it can grow its industrial side large enough to keep it going. GE is not going to go anywhere, its a monster player in energy and aerospace…and anything that has dropped 30% has a good chance of bouncing up. But as a long term bet, makes me a little nervous.
Where were these numbers? Here was GE’s most recent 10-q statement at the time:
GE’s cash from operations are stated on it’s statement of cash flows:
Comparing dividends to a company’s profits and cash flow are a couple easy basic checks that investors can use to check their expectations of dividends are realistic.
One last Check To Determine Dividend Sustainability
Recently the Wall Street Journal (WSJ) mentioned a more unique “screen” to determine if a dividend is sustainable that I thought was interesting.
In the article the WSJ highlighted the strategy of buying high dividend paying company’s who also spend significant amount of money on research and development. The thought is that the company is ensuring unique products and technology will continue to be released, and that the company is not sacrificing future growth by paying large dividends now.
The WSJ compared a company’s R&D expenses with its enterprise value to filter out the companies that are spending significant money on R&D.
Dow Chemical (Ticker: DOW) – Dividend yield of 3.8%
Intel (Ticker: INTC) – Dividend yield 4.5%
And Johnson and Johnson (Ticker JNJ) – Dividend yield of 3.5%
Just one of the many ways investors can try and determine if their investments are able to pay dividends for decades to come.
In Conclusion- Is Your Dividend Safe?
Remember, investing works best when you find great long term investments that appreciate year after year over decades. Because a company is offering a dividend today, does not mean that dividend can continue forever. Dividend yield is an important factor in your choice of an investment, but be sure to check that the dividends are sustainable. Buying a company because of a high dividend today does not mean your investment will be there tomorrow.
These are just several ways to use a company’s financial statements to determine the sustainability of a company’s dividends.
What else do you use to help determine if a company can continue to pay its dividends?