Dividends are offered by some companies that are traded on the stock market, but… Dividends are never guaranteed, sometimes they get cut. I have been stung many times by companies suspending dividend payments, it’s not nice to have your income cut overnight. But there are some telltale signs that you can use to avoid the surprise.
So… How can you tell if your dividend is at risk? The main factor that indicates a dividend is going to be suspended is if the Dividend Coverage Ratio is below 1.5, that is the ratio between the Earnings per Share, and the Dividend per Share, this ratio could show that the company cannot afford your dividend. Dividends are complicated contracts that can be affected by a multitude of factors including:
- Financial Difficulties
- A Plan for Future Growth
- Dips in the Overall Market
- Company structure changes
There are many factors that can affect a dividend payment, the average Dividend Yield of a company on the S&P 500 over the last 60 years was between 2-5%, which isn’t anything to scream about, but it’s safe. Most dividend investing strategies are based around picking safe companies. So let’s look at what makes a safe company, and how to tell when things are going south.
7 Reasons your dividend might be at risk
First things first, dividend suspension can be because of one of the following reasons, or a mixture of a lot of them, so you’ll have to do your research and keep a close eye on your investment.
Is the company in financial trouble?
Financial strain is the number 1 reason why companies suspend dividends. Because dividends are issued to shareholders out of the company’s retained earnings, a company that is struggling financially may choose to stop paying dividends to protect its cash reserve for future expenses.
If sales are down, or costs go up, the amount of money left over for dividends at the end of the year will be reduced, or maybe even nonexistent. Suspensions can be announced out of necessity, meaning the company has no profit for the period, hence no equity to give out. Or the Financial Officers might be proactive, and plan for lower profit margins, meaning they will not warrant non essential spending like dividend payments.
You need to be on the watch for changes in company structure, imports and exports, and any other changes in the overall economy that will impact companies in your portfolio. The best place to start is by learning how to read a company’s quarterly earnings reports, this will give you a good idea of where the company is headed, as well as how they performed in the last 3 months.
Does the company have a high Dividend Payout Ratio?
Dividend payout ratios show us how much of a company’s profits are being given to investors.
Since the 1930s the companies on the S&P 500 have decreased the proportion of profits paid out in dividends. The main reason is because companies cannot sustain big cash deficits due to high dividend payouts. This table is from a 2006 Eaton Vance Post.
|Decade||Market Price Change (%)||Average Dividend Payout (% of profit)|
Yes higher dividend payout ratios mean more money to investors, but if the company cannot afford the high dividend yield, the dividend won’t be paid. It’s no good getting paid a dividend ratio of 80% when the company could go bust next year.
I look for a dividend payout ratio of between 10% and 40% depending on the growth potential of the company. The higher the growth potential the less concerned I am about dividends, because we can make money on the appreciation of the stock.
You can calculate the Dividend Payout Ratio by taking the Dividend per Share (DPS) and dividing it by the Earnings per Share (EPS), both of which are easily accessible from Yahoo Finance. You should always look at no fewer than 6 quarters of ratios, this will give you an idea of whether the company is trending up or down.
Are the owners funding future growth?
You will normally find this is the reason for dividend cuts for newer companies. Announcements will be made when a company decides to cut dividends, which will often come with an explanation. This is by far the best explanation.
Many investors will jump ship at the sound of a dividend cut, but if the company is funding growth, they could be missing out on increased earnings in the future, either by appreciation of the stock, or higher dividend due to increased profits.
Dividends are paid from a company’s retained earnings. If a company is planning for growth you may see a dip in the retained earnings on the company’s balance sheet. This reduction may be because of a big purchase, or an increased expense to facilitate an industry shift.
Have a look at the company’s schedule and put notes on your calendar about major board meetings, voting dates, and earnings report publishing dates. Another thing you should keep an eye out for is moves in industry, or major asset purchases. All of these can lead to announcements of future growth being a priority.
Does the company owe deferred dividend to preference shareholders?
There are multiple types of shares, the most common are those you can buy on the exchange (ordinary shares), another type are preference shares. Preference shares are given out at the discretion of the issuing entity, but are usually issued to founders, head executives, or majority shareholders.
These preference shares have a set guaranteed amount of dividend that needs to be paid each year. This is usually larger than the typical dividend we receive.
Because the amount is guaranteed, if the company can’t afford payment to preference shareholders, it needs to either generate extra profit, or cut expenses, and the most common expense they cut is regular dividend.
Preferred dividend must be paid before regular dividend. It’s just the way things are. Again the best way to find this is to dive into the earnings reports. Reports have line items classified as preference shares and ordinary shares. Increases in preference shares but a reduction in profit is bad for dividends.
What is the current inflation rate?
This sounds like an easy one, and it is. If the overall economy experiences a dip, or inflation rate increase it means everything becomes more expensive.
Recently in 2020 we have seen the world swan dive into recession, meaning companies across the world have seen a reduction in revenue, and an increase in expenses. Boeing (BA) which has grown its dividend for the last 10 years has suspended dividend payments.
This is mainly due to the fact people are not flying during this crisis, but we must look deeper. Is this dividend cut solely because of the overall economy, or is it a company problem. I think Boeing will bounce back, but we need to see increases in the economy before we will see any dividend.
The main takeaway from this section is that private sector companies thrive during strong economies. When the people aren’t buying, the companies aren’t making money. Some established companies can weather the storm, but a lot can’t so you’ll have to be logical in your decision making.
Is there a dip in the Dividend Coverage Ratio?
This is similar to the Dividend Payout Ratio, but this calculation tells us whether the company has enough profit to afford the dividend payments. It is safer to know if a company can afford a dividend before investing.
It is simple, you take the EPS and divide it by the DPS:
This indicates how many times a company can pay its dividend. Any figure under 1 means a company will definitely have to cut its dividend, anywhere between 1 and 2 means the company may need to cut dividends as most of its free cash is going to investors.
People say the higher this number the better… But if a company has a dividend coverage of over 5, it could mean the company is being a bit greedy, it is still a good company to invest in, but investors aren’t properly being compensated for their support.
Aim for a Dividend Coverage between 2 and 3, this gives the company a cushion incase of unexpected expenditure. Again you should calculate this ratio for the last 6 quarters to give you a historic record of trend.
Read the Cash Flow Dividend Coverage
This is used by more advanced analysts, but it is a great ratio to base your research on.
Because companies have preference shares and other capital expenses, we cannot trust just the earnings reports for the amount of free money available for common shareholders. So we use the free cash flow left at the end of the year.
All of these figures are available for free on Yahoo Finance.
A good figure is anything over 2.5, anything below 1.4 could indicate the company has poor cash flow, or has larger than usual capital purchases. You will have to determine which one, because as we mentioned before, big capital purchases could mean a plan for growth.
As much as this is similar to the Dividend Payout Ratio, it is good to see a contrast between profits that are paid out, and the amount of cash available, if these figures don’t match, you could be in for a dividend cut because the company simply can’t afford it.
What impact does dividend suspension have on share price?
Unfortunately you guessed it, a dividend suspension or cut has a negative impact on a companies share price.
Here are 8 companies that suspended or cut their dividend during the first quarter of 2020, and the resulting change in share price 1 week from the cut/suspension:
|Company||Previous Dividend per Share||Dividend Cut (%)||Change in Share Price (%)|
|Alliance Data Systems||$0.63||-67%||+17.9%|
|Estee Lauder||$1.92||Full Suspension||-7.5%|
|Dick’s Sporting Goods||$1.25||Full Suspension||-10.2%|
|Las Vegas Sands||$3.16||Full Suspension||-12.7%|
|Goodyear Tires||$0.64||Full Suspension||-2.2%|
|General Motors||$1.52||Full Suspension||0.3%|
To determine whether or not it is worth holding onto the stock, you need to look deeper into the company’s financials, and try to understand their future plan. If the company looks strong or they have released plans for the future, you can tell if they expect to bounce back.
As you can see from the table, it is not always a bad thing when a dividend cut happens. The company can still be desirable without the dividend.
Can a company that cuts its dividend start paying again?
Yes, as long as a company is still trading on the exchange they can offer dividends to investors. They are not obligated to, however it is becoming general practice for more blue chip stocks to do.
Companies such as Amazon, Berkshire Hathaway, and Facebook have never paid dividends to investors, so they are solely offering earnings in terms of appreciation.
No one can tell when a company will begin to issue dividends after a suspension or cut, it is completely down to the company managers. But if profit is recovering, and liabilities are reduced, you can be confident the company owners will think about paying dividends again.
What are some safe companies to invest in for strong dividends?
Here are 20 companies that have grown their dividends for over 30 years. Dividend growth is a huge factor when it comes to safety of investment, if a company has a good track record for paying dividends, you can be more confident in future payments. Some of these companies also feature on the S&P 500’s Dividend Aristocrats list, a list of companies that have grown their dividend for the past 60 years.
|Stock Symbol||Company Name||Years of Dividend Growth||Annual Dividend in 2020|
|AWR||American States Water||65||$1.22|
|PG||Procter & Gamble||63||$3.16|
|ITW||Illinois Tool Works||56||$4.28|
|WBA||Walgreens Boots Alliance Inc.||44||$1.83|
|THFF||First Financial Corp||33||$1.04|
Please do your own research on the companies on this list, dividend safety is only one aspect of choosing an investment. For more information head over to our investing essentials page.