Dividend companies share profits with their shareholders by paying out dividends. This is income that shareholders can use for whatever they want, whether that’s reinvesting it or using it to pay the bills.
However, companies aren’t obligated to pay dividends. In fact, they can cut or even eliminate them any time.
How can you reduce the likelihood of a dividend cut? Here are a few things you can do.
Is the yield sustainable?
Anytime you see a yield higher than 7%, you should question whether that distribution is safe or not. However, just because a company pays a yield of, say, 5%, that doesn’t automatically make its distribution safe either.
Dream Office Real Estate Investment Trst (TSX:D.UN) yielded more than 20% in 2008. However, it maintained its funds from operations (FFO) per unit and its distribution throughout the recession.
In 2015 Dream Office’s adjusted FFO payout ratio was more than 100%. So, fundamentally, it was impossible to maintain its distribution unless it borrowed or used the distribution-reinvestment program as a cushion.
The real estate investment trust ended up slashing its distribution by a third in February this year.
Is the management willing to maintain the dividend?
Even when a company’s payout ratio is well below 100% and sustainable, the management can still choose to cut it. In the case of Dream Office, a part of the reason for cutting the distribution was to improve the company’s balance sheet.
Investors can look at a company’s distribution history as an indicator of a cut. Although Dream Office maintained its distribution throughout the last recession, it has hardly increased its distribution. (But, to be fair, most Canadian REITs don’t have a consistent record of growing their distributions every year.)
If you were to compare two companies in the same industry that have sustainable payout ratios, the one that has a history of hiking is distribution offers a safer dividend because that shows the management’s commitment to the dividend.
How much margin of safety is needed?
Some investors think of dividends as a cushion against the downside; they’re still getting a positive return when share prices decline.
That’s true to an extent. However, just because you decide to invest in a dividend stock doesn’t make it less essential to buy it at a reasonable (or even discounted) valuation.
In fact, the higher the yield of a stock, the bigger margin of safety you should ask for. Why is that? Typically, high-yielding stocks have little to no growth.
That’s because they are paying out most of their earnings or cash flows. So, there’s little capital left to reinvest into the business for growth.
From 2005 to 2015, Dream Office’s FFO per unit increased by 8%. That equates to annualized growth of only 0.78%. No matter how enticing its yield is, investors should wait for a big margin of safety (of at least 30%) due to its slow-growth nature.
Bank of Nova Scotia gives Dream Office a 12-month price target of $19 per unit. A 30% margin of safety implies a price of $13.30 per unit.
To avoid dividend cuts, investors should look for companies with sustainable payout ratios. And management must be committed to maintaining or, better yet, increasing the payout. Moreover, the slower a company grows, the bigger the margin of safety investors should ask for.
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Fool contributor Kay Ng owns shares of Bank of Nova Scotia.