In this low-interest-rate environment, dividend investing is very popular. Where else can you find 4 percent yields in quality companies—particularly yields that are growing every year?
So it’s no surprise that investors are pouring their money into dividend stocks and chasing yield.
But investors should have a clear understanding of what they’re getting themselves into. Picking a stock with a low dividend yield won’t be as destructive to net worth as picking a higher-yielding stock that cuts its dividend.
Typically, when a company cuts its dividend, the share price falls hard. Even leaving the dividend the same can be seen as extremely negative if a company has a long track record of raising dividends.
So when investing for income, yes, you want to receive a solid yield and one that is growing every year. But you need to ensure that the dividend growth is sustainable.
Look at a company’s payout ratio. The payout ratio is the percentage of a company’s profits that is paid out in dividends. The calculation is simple. Divide dividends paid by net income.
If a company has $100 million in profits and paid out $50 million in dividends, the payout ratio is 50 percent ($50 million divided by $100 million).
Generally speaking, I look for companies with a 75 percent payout ratio or less. That way, if the company reports weak earnings, there is still enough of a buffer to continue to pay (and hopefully raise) its dividend.
Let’s look at a real life example.
Medtronic (NYSE: MDT) has raised its dividend every year for thirty-five years. Over the past twelve months it has earned $3.66 billion. During the same period it has paid out $1.03 billion.
Divide $1.03 billion by $3.66 billion and we get a payout ratio of just 28 percent. That tells me the company has plenty of room to raise the dividend, even if earnings are subpar going forward.
Considering that the company has raised the dividend every year since the Carter Administration, you can be fairly sure that the company will do everything in its power to raise it again next year, no matter what kind of earnings it reports.
Cash Flow is King
Net income is great. We definitely want our companies to be profitable. But there’s an even better metric to use instead of net income—cash flow.
Net income is calculated using revenue, expenses and all kinds of made-up accounting tricks like depreciation, amortization, non-cash compensation, etc.
Cash flow more accurately represents how much cash a business took in. Since dividends are paid with cash, not with earnings, I also use cash flow from operations to determine the payout ratio.
Here’s an example:
AT&T (NYSE: T) has raised its dividend for twenty-eight consecutive years. Over the past twelve months it earned $4.68 billion and paid out $10.28 billion for a payout ratio of 219 percent. That could be a scary figure. After all, a company paying out more than twice its profits in dividends might not be sustainable.
But when we look at cash flow from operations, we see that the company generated $35.35 billion in cash flow, making the payout ratio based on cash flow a very comfortable 40 percent.
So even though the company’s profits were less than $5 billion, it actually brought in over $35 billion in cash.
Naturally, I’d always like to see higher net income, but as long as the company is generating enough cash to sustain and raise the dividend, I feel confident that it is secure.
A payout ratio starts creeping above 75 percent is a yellow flag. If it continues heading higher, you may want to start looking for a different stock. Dividend payers tend to be safer investments than the average stock. The last thing you want is to get hurt because your dividend payer cut its distribution.
Marc Lichtenfeld is the author of Get Rich with Dividends, A Proven System for Earning Double Digit Returns, the Associate Investment Director of the Oxford Club and the Editor of the Ultimate Income Letter.