As you learned in the dividend yield lesson, dividend stocks with the highest yield have historically underperformed compared to those with a lower one because high dividend yield stocks usually come with higher risk.
Indeed, while a high yield seems attractive to investors, an unsustainable distribution to shareholders can lead to a dividend cut and a drop in the stock price.
In this lesson, you will learn how to recognize an unsafe dividend before it's too late with six metrics that will help you determine if a firm’s distributions to shareholders are sustainable in the long run.
In this article
1# Dividend Payout Ratio
The dividend payout ratio is a popular metric that tells you the percentage of earnings that a business distributes to shareholders as dividends. It is equal to the total dividends paid to shareholders divided by the latest twelve months' net income.
Dividend Payout Ratio = Total Dividends / Net Income
With a dividend payout ratio higher than one (1), the company pays shareholders more than it earns. It is a big warning sign that could foreshadow a dividend cut and a stock price crash.
However, the company's cash flow may be greater than earnings, and the dividend may be safe despite a high payout ratio. To make sure that this is the case, you can look at the dividend coverage ratio.
2# Dividend Coverage Ratio
The dividend coverage ratio is a less popular financial ratio that measures how many times a firm's cash flow from operations covers the dividend. If a company makes $20B in operating cash flow and distributes $10B in dividends, the coverage ratio is 2x.
Dividend Coverage Ratio = Operating Cash Flow / Total Dividends
While earnings represent only a number on the income statement, the company can't pay any dividends if it doesn't have the cash to do that. Thus, it is worth using the dividend coverage ratio to make sure that a business can handle its dividend with ease and that you're picking the right dividend stocks.
3# Dividend Per Share Forecast
One of the most important investing rules is to always do your own research and never base your investment decisions on what others say about a particular stock.
However, overconfidence and confirmation bias could lead you to make bad investment decisions. Thus, it could be very helpful to take a look at analysts' forecasts and double-check that you didn't miss anything.
As you can see in the picture below, you can use the Finbox Data Explorer to access dividend per share forecasts for 100,000+ stocks worldwide. If you find dividend stocks with a forecast like Coca-Cola (NYSE:KO), you have the confirmation that analysts are very bullish on the companies' dividend.
4# Interest Coverage Ratio
While analyzing dividend stocks, it could be very helpful to look also at a company's debt. How can a company pay dividends if it doesn't have enough money to sustain its debt?
The interest coverage ratio is a debt ratio that measures how easily a firm can pay interest on outstanding debt with its available earnings. It is equal to a company's earnings before interest and taxes (EBIT) divided by its interest payments owed in the corresponding period.
Interest Coverage Ratio = EBIT/Interest Expense
With an interest coverage ratio lower than 1.5, a company's ability to meet interest payments and dividends should be questioned.
5# Cash Flow To Total Debt Ratio
The cash flow to total debt ratio is another popular financial metric used by investors to evaluate a company's ability to handle its debt with its operating cash flow.
Cash Flow / Total Debt = Operating Cash Flow / Total Debt
You can use this metric to measure how many times a company's operating cash flow covers its debt. Another way to use it is to invert the formula and see how many years it would take the company to pay off its debt.
In his book, What Works On Wall Street, James O'Shaughnessy divided the entire U.S. stock market into ten (10) deciles based on cash flow to total debt. Not surprisingly, companies with low cash flow to total debt drastically underperform the market.
In the 45-year backtest period from 1964 to 2009, stocks in the lowest decile for cash flow to total debt posted a 2.41% CAGR compared to the 11.22% CAGR of the whole market.