By: Wayne Duggan
Interest rates are near their lowest levels in history, giving yield investors few viable options for generating reliable income. One of the best ways for investors to get quarterly income is by owning stocks that pay dividends. Unfortunately, a stock’s dividend is only as good as the company that pays it.
Here are three things to look at to determine whether or not a dividend is at risk.
1. Payout Ratio
Payout ratio is a financial metric used to assess the financial strain a stock’s dividend payment is putting on the company. Payout ratio is simply the company’s annual dividend payment per share divided by its annual earnings per share, and it tells investors what percentage of the company’s total earnings are going right back out the door to cover its dividend.
Ideally, a company’s payout ratio would be below 50%.
For example, AT&T shares pay an attractive 6.7% dividend, but the company’s payout ratio is above 130%. In 2019, prior to the pandemic, AT&T reported $1.89 in EPS. That same year, the stock paid out $2.04 in dividends per share. AT&T might not cut its dividend any time soon, but it is certainly putting a strain on the company’s finances at the moment.
2. Dividend History
One of the best predictors of what a company is going to do in the future is what it has done in the past. Before snatching up shares of a stock paying a 6% dividend, check to see how those dividend payments have changed in the past.
For example, AT&T’s payout ratio may be high, but its history reveals a company that is deeply committed to its dividend. AT&T has been consistently raising its dividend by four cents per share going back to 2008. Even during the financial crisis, AT&T was raising its dividend. A company that has been committed to maintaining and even raising its dividend during hard times is probably less likely to cut it in the future.
3. Long-Term Revenue Trends
The final red flag that a dividend may be too good to be true is that the underlying company is in secular decline. For example, paper company International Paper pays an attractive 3.6% dividend. However, the company’s trailing 12-month revenue is down more than 20% over the past decade, and many investors see global digitization as a long-term threat to the paper industry.
Tobacco companies, oil companies and shopping mall retailers are just three examples of the types of companies that may not be able to survive in the long term. Counting on these types of companies to keep paying their dividends two or three years down the road could be risky.
The author holds no position in the stocks mentioned.
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