Dividend-focused stocks are a great way for investors to get current income while hoping for growth of initial investments.
However, just because a company is paying a very high dividend does not make it a better investment than a lower yielding company. A large threat to dividend stocks is when the company is forced to reduce or even stop paying the dividend altogether. When this happens, shareholders are hit two-fold, with a reduction in income and more than likely a decline in the share price. Knowing the warning signs about when a company is about to cut its dividend is extremely helpful for investors and should allow them to cut their losses to a minimum before the real damage is done.
One of the most famous examples of this scenario is General Motors (GM ). General Motors had a reliable dividend for several decades and was considered a blue-chip stock. From 2003 to 2006, the company saw its stock price decline from $60 per share to $20 per share. This caused the dividend to yield upward of 10%, which seemed very attractive to investors. However, in 2006, GM’s management announced they were cutting the dividend in half to $0.25 per share. Two years later, as the economy was tumbling and the financial crisis was in full bloom, GM altogether cut its dividend. The stock plummeted and eventually, GM filed for bankruptcy in 2009, although it became a publicly listed entity again in 2011 after emerging from the bankruptcy proceedings. Nevertheless, in this process, shareholders of GM not only lost the stock’s dividend payments, they also lost their original investment as the stock price went down to $0.
You can find an updated list of companies that recently announced changes in their payout policies, along with their ex-dividend dates, in our Dividend Payout Changes and Announcements tool.
Warning Signs to Watch
Here are the top 4 warnings that a dividend investor should be aware of while monitoring a potential reduction or suspension of a dividend.
1. Missing Revenues and Earnings Estimates
One of the earliest signs of a company that is about to cut its dividend is that it continually misses its revenue and earnings expectations. Dividends are typically derived from profits from the company. If a company has declining revenues, it will have a tough time keeping its earnings stable. Thus, a sustained decline in earnings is likely to lead to a potential decline in dividends going forward. In the example of GM again, in 2002, the company had an earnings per share of $3.35. It steadily declined in 2003 and 2004 to $2.40 and $1.59 per share, respectively. In 2005, the company took a big hit and saw negative earnings per share of $6.14, sparking the dividend cut of 50%.
Click here to learn more about some of the biggest collapses of dividend stocks.
2. Excessive Debt or Pension Obligations
Companies that have extensive debt or pension obligations are in clear danger of cutting their dividend. This gives management very little wiggle room in terms of its financial cash flow, with margins being squeezed by both interest payments on the debt as well as obligations to pay the dividend. In the end, a company will always pay its interest payments first in order to avoid going into default.
Typically, this is measured by a company’s debt-to-equity ratio. The higher the ratio, the more leverage the company is facing. However, this may not be accurate depending on the company’s business. Financial institutions and banks often have higher debt-to-equity ratios because they borrow money to lend money. In this situation, the banks borrow at a lower cost than what they pay in interest and, therefore, profit on the spread. Capital intensive businesses also have a higher-than-normal debt-to-equity ratio because they borrow to buy equipment which will then help drive future revenues.
A more accurate measure is to compare the current debt-to-equity ratios to historic debt to equity. If there is a sudden uptick that is unlike its typical measure, this might be a sign the company is adding too much debt to quickly to pay off or else its revenues are declining so much that the debt is spiraling out of control.
3. Low Return on Capital Employed (ROCE)
Return on capital employed (ROCE) is calculated by looking at a company’s earnings before interest and taxes (i.e. EBIT) and dividing it by the capital employed. Simply put, ROCE is a great way to measure how efficient a company is running. Companies with a high ROCE tend to be more profitable and, thus, are growing over the long term. Companies with a lower ROCE are the opposite and are constantly having trouble with their growth.
A relatively high ROCE is likely to indicate that the company should have sustainable cash flows to both reinvest and pay dividends. So, for example, Company A and B both have EBIT of $10 million but Company A has $40 million in capital employed, while Company B has $20 million. Even though both have the same EBIT, Company B has a higher ROCE of 50% versus Company A of 25%.
4. Too High of a Yield to Sustain
Investors should always be wary of a dividend yield that is very high and almost too good to be true. This is usually a clear indication of either a major decline in the stock price, which could result in a dividend being cut. Another reason is that the dividend might be too high for the company to realistically maintain over the long run. In this case, anytime the company has a down quarter it might be forced to cut its dividend.
A good indicator to monitor this phenomenon can be to look at the company’s dividend payout ratio. This is calculated by dividing the dividend per share over earnings per share. Companies with a dividend payout ratio of over 100% are most likely in danger of being forced to cut their dividend. You can use Dividend.com’s screener to create a list like this to explore common stocks and ADRs that have a payout ratio of over 100%.
Another good measure is to look at a company’s track record for dividends. For instance, Johnson and Johnson (JNJ ) has one of the longest track records for raising its dividends, having done so for the last 55 years in a row. This shows that the company places a very high value on its dividend and the importance of not only paying it but growing it every year. Stocks that have very little track record have no real measure of management’s focus on the dividend and are, therefore, less reliable.
Want to find other stocks that have dividend increase history similar to that of JNJ or even better than JNJ? You can use the Screener at Dividend.com to create a list like this to explore common stocks and ADRs that have a history of raising dividends for 25 consecutive years or more. You can then download the screener result on a searchable spreadsheet to perform custom analysis. Stocks with the highest DARS ratings are Dividend.com’s current recommendations to investors.
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The Bottom Line
Overall, dividends are a great part of investing, as shareholders can earn income while they wait for the stock price to appreciate in value. As mentioned, not all dividends are created equal and higher is not necessarily better. Investors should look at a variety of factors and financial ratios when determining the stability of a stock’s dividend payment. If management decides to cut the dividend, it could cause a serious decline in the stock price.