About 500 companies (mostly oil and gas) cut their dividends in 2015. In 2008, this list was topped by banks. For income investors, this scenario is extremely painful because not only does their income drop, but so does the unrealised value of their portfolios. Dividend cuts are not viewed favorably by the markets. When such announcements are made, especially by dividend aristocrats, it signals a problem in the sector the company is likely to persist in the near future.
If dividends are not cut by companies, then it leads to either a negative payout ratio (loss making companies that pay dividends) or a payout ratio that’s greater than 100% (companies pay out more than they earn).
Test How Your Company Stands out on the DARS Algorithm
The DARS algorithm takes into account five of the most important dividend-related financial metrics when rating a dividend stock. Run your stock through the DARS analysis to predict a dividend cut.
Markets will react negatively towards a stock that is expected to cut its dividend. They discount everything, they say. If a company’s business outlook is expected to turn negative in the future, the stock slowly starts slipping from its 52-week high. DARS takes into account a stock’s 52-week high as the only technical indicator in our formula. Investors can use other technical factors, like bollinger bands or stocks slipping off key support levels, as they make their decisions.
As a rule of thumb, if a stock has slipped more than 10% from its 52-week high, then it demands investigation.
DARS uses a proxy to measure dividend uptrend. It believes that if a company has a stellar dividend paying record, then it isn’t likely to be valued very cheaply. Those companies that score highly on the other 4 parameters that DARS measures – but still trades at a valuation between ~13 to 20 P/E* – are rated very highly. We believe these stocks are the least likely to cut a dividend.
Stocks trading below 13 P/E may be attractive for a value investor, but not for an income investor. Stocks trading beyond 20 P/E may be attractive for a growth investor, but again not attractive for an income investor. Too low P/E stocks usually don’t have a good dividend paying history, while too high P/E stocks have unreasonably high-growth estimates built into them.
*DARS measure the P/E ratio as price divided by the current financial years earnings, thus making it a slightly forward-looking estimate.
Dividend yields are the most misunderstood numbers by dividend investors. Don’t get lured by stocks yielding higher than 5%. An ideal dividend yield should be higher than popular indices like the Dow Jones Industrial Average or the S&P 500, but it should not be too high. If a stock’s yield slowly starts moving into a territory that is higher than 5%, then it needs some investigation. This doesn’t apply to REITS or MLPs, which can yield more than 5%, as they usually payout more than 75% of their earnings as dividends resulting in large yields.
With everything else held constant, yields start rising, as the stock’s price starts falling down.
As a rule of thumb, stocks that yield between the S&P 500’s yield, and up to 150 – 170% of the index’s yield, are good stocks. The rule can be slightly relaxed for REITS and MLPs.
Dividend reliability measures how committed a company is to dividend payouts. The perfect payout range for a dividend investor who wants his company to keep growing its dividend is the 35 – 55% range. This is the ideal range, which isn’t too low or too high.
Companies that have payouts below 35% are usually new dividend payers that aren’t very reliable. These companies are transitioning from high growth to being market leaders, and are not seeing further opportunities to grow, in which case, they initiate a dividend.
Companies that have payout ratios greater than 55% are very intent on paying out dividends, but they also run a risk of cutting their payouts if they have a bad financial year. The most recent example is oil and gas companies. Their payout ratios have in fact gone over 100%, as they struggle to maintain their payout record in the face of falling commodity prices.
Management usually declares a payout range for its dividend, which is called a target payout range, defined within an upper bracket and a lower bracket of its earnings. For example, check out this target payout ratio from IDA Corp. They plan to pay out 50-60% of their sustainable earnings. The key point is that it is a percentage of earnings.
If earnings grow, then so will payouts. DARS favors a single-digit earnings estimate growth over double digit. Always check FY+1 estimates with current FY estimates. If they are between 2% to 10%, then it signals the company is growing organically and isn’t a high-growth stock.
Companies that have double-digit growth estimates have the potential to go up more when the stock markets go up, but also have the potential to go down equally fast when the stock market falls. As a dividend investor, you want low beta stocks. Thus, if a company’s next financial year’s earnings estimates are predicting to rise by single digits, then the probability of a dividend cut is low.
The Bottom Line
No single parameter in the DARS model scores highly over any other. Thus, when you put your stock through the DARS test, be sure to weigh every factor equally. You can anticipate a dividend cut and rebalance your portfolio if DARS raises a red flag.
Be sure to check out this compelling read on target payout ratios, which will give you a clear understanding of what a good payout ratio is by industry