Dividends at Risk
Income-oriented investors have recently been put between a low-interest rate rock and a risky-stock hard place. Long-term government bonds yield little real income which has pushed investors into the stock market in search of healthy dividends. Regrettably, dividends are much less certain than interest and income-oriented investors should keep a close eye on dividend stocks for signs of weakness. Fortunately, there are several ways to tell if a stock’s dividend is potentially at risk.
The easiest way to find out if a stock’s dividend is at risk is to calculate its dividend payout ratio. The dividend payout ratio simply measures how much of a company’s earnings are paid to shareholders in the form of dividends. The dividend payout ratio is calculated by dividing a company’s dividends by its earnings. For instance, TD Bank earned $1.52 per share in the last twelve months and pays an annual dividend of $1.28 per share. As a result, TD’s dividend payout ratio is 1.28 divided by 1.52 or 84%. Based on last year’s earnings, TD Bank will payout 84% of its earnings in the form of dividends. Furthermore, with a payout ratio of less than 100%, TD Bank can be expected to continue to pay its dividend indefinitely baring unexpected calamity. However, the world is a risky place and the unexpected tends to happen with alarming regularly. Truly conservative investors should be sure that the dividend is more than covered by earnings.
In Table 1 I’ve presented stocks in the S&P/TSX 60 that pay more than 75% or their earnings as dividends or dividend-paying companies that that have lost money over the past year. At first glance, the dividend of these stocks may be at risk. After all, should these stocks continue to pay more in dividends than they earn then, at some point in the future, management will be forced to cut the dividend. Naturally, a dividend cut could be avoided should earnings improve. However, investors who need to rely on dividend income should carefully review the stocks presented in Table 1 to make sure that they are comfortable with their holdings.
As proof that dividends can be risky, this fall Noranda (NRD) cut its quarterly dividend by 40% from $0.20 per share to $0.12 per share. At the time, Noranda’s stock was hurt but luckily for investors it has since climbed nicely. For a long time Noranda has paid out the vast majority of its earnings as dividends but recent losses posed too much of a strain for the firm. Nonetheless, earnings have started to improve and Noranda’s stock has recently gained a great deal on the back of strong commodities markets. Noranda’s story is similar to that of TransCanada Corporation (TRP) which cut its dividend several years ago and was punished in the market. However, TransCanada’s share price, and dividend, have recovered and even exceeded previous levels. As strange as it might seem, in some circumstances, it makes good sense for the more speculatively minded to buy stock in companies that have recently declared a dividend cut. Mind you, buying after a dividend cut can be quite painful at times. Once solid companies can occasionally sink into oblivion as was discovered by the shareholders of Laidlaw stock several years ago. Investors requiring a regular stream of income will find such circumstances to be much too speculative.
Investors should also consider a company’s recent earnings and cash flow history when searching for dividend stability. If a company has only encountered a few poor quarters, but it is likely to recover, then its dividend should be fairly safe. On the other hand, should the company be mired in a multiyear downturn then income investors ought to be concerned. At first glance, Shaw Communications appears to be such a case with the cable company failing to earn more than its dividend for the last ten quarters (See the Uncovered Quarters column in Table 1). However, appearances can be deceiving and the current risk to income investors is not overwhelming. Moving beyond earnings, one quickly discovers that Shaw’s dividend is quite small in comparison to its positive cash flow from operations. Also, with losses shrinking and cash flow growing over the last few quarters, it seems unlikely that Shaw will cut its dividend any time soon. Shaw actually increased its dividend a few months ago which makes a cut even more unlikely. Nonetheless, Shaw’s case illustrates that investors who are worried about a high dividend payout should check both the current trend in earnings and cash flow for additional clues as to the safety of their dividends.
Risk-averse income-oriented investors ought to be on a constant lookout for potential problems with their steady dividend paying stocks. Determining a stock's dividend payout ratio and backing it up with earnings and cash flow trends can help investors to spot trouble. Although I don't suggest bailing out at the first sign of weakness, it is a good idea to thoroughly investigate any dividend-paying stock for potential hazards. Capital losses can easily wipe out many years of hard-earned dividends.
First published in February 2004.
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