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Dividend investing is popular because many investors like income. Before buying stocks for dividends, investors should check the dividends are safe and if there’s a big enough margin of safety for the stocks.
Here are some questions you can ask. If the answers to some or all of these questions are “yes,” the dividend in question may be cut.
Is the payout ratio too high?
A company that has a payout ratio of more than 100% doesn’t have a sustainable dividend. In other words, the company is paying out more than it earns, and it can’t possibly do that in the long run. It’ll have to bring down its payout ratio somehow — either by cutting its dividend or growing its earnings.
In most cases, you’ll find payout ratios below 100%. To determine if a dividend company’s payout ratio is too high, compare its payout ratio with that of its peers. For example, the Big Six Canadian banks, including National Bank of Canada (TSX:NA) have payout ratios of ~50%.
If one of the big banks had a payout ratio that far exceeds 50%, its dividend will be riskier. But if there’s one with a payout ratio that is way below 50%, then it could mean higher dividend growth for that bank.
Does the company have declining earnings or cash flow?
Companies with declining earnings or cash flow can lead to slower dividend growth, stagnant dividends, or even dividend cuts. If the earnings or cash flow decline is only temporary, and the company has a margin of safety for its dividend, it may still maintain its dividend or grow its dividend at a slower pace. For example, Procter & Gamble Co. (NYSE:PG) experienced a couple of years of slow dividend growth as a result of its shedding its non-core brands.
Does the company have volatile earnings or cash flow?
Miners, such as Teck Resources Ltd. (TSX:TECK.B)(NYSE:TECK.B) and Barrick Gold Corp. (TSX:ABX)(NYSE:ABX), and oil and gas producers, such as Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG) and Arc Resources Ltd. (TSX:ARX), have volatile earnings because their profitability more or less relies on the prices of the underlying commodity prices. As a result, there’s no certainty that they’ll maintain their dividends. So, investors should buy these stocks with the goal of total returns and aim for most returns to come from price appreciation.
Does the company have large debt levels?
Debt obligations will compete with dividends for a company’s capital. By comparing the debt levels of companies in the same industry, investors can tell if a company might have too much debt.
Crescent Point’s recent cash-flow-to-debt ratio was 0.25. Comparatively, Encana Corp.’s (TSX:ECA)(NYSE:ECA) recent cash-flow-to-debt ratio was 0.12. So, Crescent Point’s cash flow more readily allows it to support its debt obligations. However, both ratios seem low. So, investors looking for safer investments should look elsewhere, unless they’re bullish on the energy industry.
There are many factors that determine if a dividend is here to stay or expected to go away. In the end, it’s the management who decides on the dividend policy. So, even if a company has a sustainable payout ratio, management can still decide to cut the dividend if they find a better use for the capital.
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Fool contributor Kay Ng has no position in any of the stocks mentioned.