Dividend investing is a great way to build a passive income but determining how safe your dividends are is a critical skill.
For example, 2020 presented a very unique year for investing and knowing how to determine dividend safety was even more important. From February 2020 to July 4th, there were over 300 companies that cut their dividend. That accounts for almost 10% of all dividend-paying companies.
1. Payout Ratio - The First Step to Determine Dividend Safety
The dividend payout ratio is a simple proportion of the total dividends divided by the net income of the company. This percentage gives you quick insight into how “safe” a dividend might be by how much of the earnings are being used to pay for them. If a company has a low payout factor, it can survive lower earnings without affecting the dividend.
Below are some average payout ratios by industry.
Another way to calculate the payout ratio can be dividends paid divided by cash flow from operations. If the cash flow payout factor is less than 75%, it would be considered to be a safer dividend.
2. Review Earnings - The Second Step to Determine Dividend Safety
Dividends are a tool companies use to pay investors with a portion of their profits. Earnings fund dividends! No earnings = No dividends. Thinking of this a different way that might hit home (pun intended), think of dividends as your mortgage or rent payment. If you lose your job, you would want to keep paying but do not have any money to do so. Many companies have that same issue and then cut or suspend their dividend.
So when looking at earnings are they at least steady or growing, declining revenues or a steep drop in earnings would be concerning. Is the reduction temporary, or will it last a long time? You can easily compare the company’s earnings on a quarterly and annual basis on any investment site.
3. Financial Strength - Third Step to Determine Dividend Safety
What I mean by financial strength is the amount of debt and cash that the company has. Back to the mortgage comparison, if a person has low debt and a large amount of savings, it is unlikely a temporary downturn will result in long term changes.
I like to look for companies with lower debt that is well laddered. Additionally, the company should also have some savings & investments to weather some ups and downs in earnings.
4. Commitment - The Fourth Step to Determine Dividend Safety
A company’s commitment is something that most people do not realize it is a significant factor. A company that has paid dividends for 20 years and has earned investor’s trust, do you think a company wants to mess it up? What has a company done in previous economic downturns?
I have mentioned in previous posts that companies have achieved certain statuses that companies will not want to lose anytime soon:
- Dividend Aristocrats – S&P 500 companies that increase dividends every year for 25+ years.
- Dividend Kings – companies that increase dividends every year for 50+ years.
- Dividend Champions – companies that increase dividends every year for 25+ years. (The difference between dividend Aristocrats & Champions is that the Champion list is updated monthly instead of yearly and that they do not have to be part of the S&P 500.)
Side note – Dogs of the Dow is another dividend group, but this is not a commitment title like the other mentioned. The Dogs of the Dow is a unique investment strategy of picking the top 10 highest yielding Dow stocks, which are probably a bit out of favor as that is what drove the yield higher.
A little research can go a long way to protect your investment by following the four-step dividend analysis detailed above. Focusing on payout ratio, earnings, financial strength, & commitment goes a long way.
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