Sometimes, the best offense is a good defense.
While I'm not anticipating a big wave of dividend cuts like we saw in 2008 and 2009, it's always best to be on your toes in any market environment (even one like this, where there are far more positives in play than negatives).
Because the truth is, a dividend cut can strike anywhere at any time. And the punishment is usually severe.
Fortunately, there are four tell-tale warning signs that can help you steer clear:
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1) Distributions that Outweigh Earnings. A company can't pay out more than it takes in -- at least not for long.
Regular readers have probably heard me talk about payout ratios. This simple calculation measures dividend payments as a percentage of profits.
For example, Home Depot (NYSE: HD) is handing out $5.44 in yearly dividends, supported by $7.29 in annual earnings. That's a payout ratio of 74% ($5.44/$7.29). Inverse these two figures, and you get a coverage ratio of 134% ($7.29/$5.44), meaning the company rakes in $1.34 of net income for every $1.00 it pays out.
It's two different ways of expressing the same thing.
The sweet spot for most companies is a payout ratio of around 40% to 60%. Too low, and you probably aren't getting a good yield. Too high, and the payout might be on thin ice (especially if earnings slide). Right in the middle leaves wiggle room for downturns -- as well as future hikes.
But that's just a loose rule of thumb.
Keep in mind, some industries commonly pay out more. Real estate investment trusts (REITs) and master limited partnerships (MLPs) must distribute at least 90% of their taxable income to maintain their federal tax-exempt status.
Generally, though, be leery of companies with payout ratios near (or above) 100%. They might be able to maintain payments for a while using retained earnings or even debt. But the longer the business stays in a slump, the more likely it will have to eventually reset payouts at a lower level.
It's safer to look for comfortable margins of safety, where payments can be maintained even in down years when profits decline.
2) Inadequate Cash Flows. The earnings presented under generally accepted accounting principles (GAAP) are useful but don't always tell the whole picture. In some cases, they can be downright misleading -- either understating or overstating profits.
A company that reports $1.00 per share in quarterly earnings doesn't necessarily take in $1.00 in operating cash flows after all the bills are paid. It might have pocketed $1.20 that period, or $0.80. That's because there are numerous one-time events that can be added to or subtracted from the bottom-line, even when no money changes hands. They include non-cash items such as amortization, depreciation and stock options compensation. GAAP earnings are also subject to manipulation, but that's a topic for another day.
I often use supplemental metrics such as funds from operations (FFO) and distributable cash flow (DCF), which are reconciled with earnings by adding back non-cash charges. I think they provide a truer picture of a firm's dividend-paying capacity. REITs and MLPs, for example, incur hefty depreciation and thus generate more cash than net income. But some companies produce less cash than net income -- and are thus less capable of meeting dividends than would first appear.Imagine a business that has been reporting quarterly earnings of $2.00 per share and paying out dividends of $1.00. The financial sites will report a seemingly safe payout ratio of 50%. But what if the company only generates $0.90 in cash flow. You might have a problem.
How could that happen? Easy. A manufacturer might send a large merchandise order to a retail customer and book it as a sale, but then extend generous credit terms and not collect the revenue until a future period.
It's also common for companies to sell off assets and record a gain from the proceeds. It's a perfectly legitimate transaction. But you can't count on this money to sustain future dividends. It's a one-time event. What happens next quarter when there isn't a sale?
With all this in mind, take a few minutes to familiarize yourself with the cash flow statement, which strips out the impact of one-time gains and losses and reflects the true amount of cash flowing in and out of the business.
Don't forget to subtract capital expenditures on property, plants and equipment from operating cash flows to get free cash flow (FCF). This is the pool of cash that is used to pay dividends, repurchase shares, or make acquisitions.
If a company has weak (or negative) free cash flows, then you must ask yourself where the money is coming from to continue supporting the dividend.
3) Excessive Leverage. When used properly, debt can be a powerful tool. If a business is generating returns on invested capital (RoIC) of 15%, it makes financial sense to borrow money cheaply at 5% to expand and create shareholder value.
But leverage can be a double-edged sword. Problems that might not be visible on the income statement lurk on the balance sheet. Too much debt can be dangerous. How much is too much? Unfortunately, there is no specific answer. Financing needs, capital requirements, and other factors vary from industry to industry.
One simple evaluation tool is debt-to-EBITDA. A ratio of 4.0 means it would take four years for a company to repay loans using current annualized cash flows. Debt-to-equity is also useful. But what's reasonable for one company might be high for another. You can't compare an automaker, for example, with a bank.
Credit ratings can give you a good idea regarding a company's ability to service its debt. A ratings downgrade indicates that there has been a deterioration in the outlook.
Keep in mind that while debt levels are important, so too are maturity dates.
I pay close attention to the current ratio (current assets/current liabilities), a short-term liquidity gauge. If a company has $10 million in cash, accounts receivable and other assets against $5 million in notes payable and other current liabilities, then it has a ratio of 2 -- meaning $2 on hand to pay every $1 owed over the next 12 months.
That's comfortable. But if those figures are reversed and there is only $0.50 to pay every $1 owed, then you might be looking at a company in financial distress. Lenders keep a close eye on asset coverage ratios -- and for good reason.
The point is, too much debt can be a heavy burden, particularly in a rising rate environment when borrowing costs rise. While dividend payments are completely voluntary, loan payments are decidedly not. So if a company is on the ropes, these elective payments are likely to get the ax. And if a company's credit line is maxed out, it often raises funding by issuing new shares, which can also put downward pressure on a stock.
4) The Business is in Terminal Decline. They say that if a business isn't growing, then it's dying.
That's seldom true. Just about every company on the planet goes through the occasional slump -- even profit powerhouses like Apple (Nasdaq: APPL). Oil prices are notoriously cyclical, but that hasn't stopped ExxonMobil (NYSE: XOM) from raising dividends for 37 straight years.
So temporary downturns don't automatically trigger dividend cuts. Great businesses can hunker down and usually have a reserve stockpile of cash for a rainy day.
But I get concerned when there is a development or trend that could impair a firm's cash flows for years to come. Or potentially worse, a disruptive threat to an entire industry.
Embattled companies can fight back by launching innovative products, tapping into new markets or finding ways to reinvent themselves. But even if these initiatives work, they are often costly and take time. In the meantime, dividends must often be sacrificed to preserve cash and shore up the balance sheet. This might well be the case with GameStop (NYSE: GME). The struggling video game retailer is losing the battle against digital downloads in much the same way that internet video streaming doomed physical movie rental chain Blockbuster. The chain has shuttered 150 locations, and the incoming new CEO has promised a complete overhaul. Can it work? Possibly. But in the meantime, I have my doubts about the firm's outsized 14% dividend yield.
Don't Be Blindsided
Dividend cuts rarely come out of left field. They are often preceded by a falling share price, which reflects dimmer cash flow prospects and other market concerns. But there are also a lot of false alarms, where shares tumble (and yields spike), yet the company is able to successfully navigate the downturn and maintain payments. These often turn out to be big winners.
The biggest challenge is differentiating one from the other.
Dividend cuts aren't a death sentence for a stock. A company can only pay out a portion of what it earns. If the playing field changes and earnings fall, then distributions must be set at a lower level. And if conditions improve, they can be raised as quickly as they were lowered.
Nevertheless, we don't want to step on these landmines. Monitoring debt levels, payout ratios, cash flow generation, and business/industry fundamentals can help put you on the right path.
(This article originally appeared on StreetAuthority.com.)