1 Huge Reason to Avoid Dividend Stocks

Dividend stocks like Algonquin Power and Utilities often look appealing… until their dividends are cut.

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Dividend stocks are very popular these days. Offering regular cash income, they provide one source of returns that doesn’t depend on you successfully betting on stock price movements. The fact that dividend stocks pay regular cash makes them feel ‘safer’ than other types of stocks. However, that perception is largely an illusion. While there is some correlation with long-term dividend payments and financial stability, that doesn’t mean that every stock which pays a dividend is safe. In fact, “high yield” stocks are sometimes among the riskiest stocks out there. In this article, I will explore one big risk to watch out for when investing in dividend stocks.

Dividends can be cut

By far the biggest risk you need to be aware of with dividend stocks is the possibility of the dividend being cut. If a company is paying out too high of a percentage of its earnings as dividends, then it will have to cut the dividend. That is, it will have to reduce the payout or even eliminate it entirely. What happens when this occurs is that your expected dividend income declines, and you will probably experience the stock price going down as well. So, your total return is hit on two fronts: lower dividend income and a falling stock price.

How to know if a dividend will be cut

The simplest way to gauge whether a stock will cut its dividend is to look at its payout ratio. The payout ratio is defined as dividends per share divided by profit per share. “Profit” in this case could be conventional earnings per share (EPS), or something else like free cash flow per share. In either case, if the amount of dividends being paid exceeds the amount of profit, then the dividend is at risk of being cut.

Two good examples

Two good examples of Canadian dividend stocks with very different dividend cut risks are the Toronto Dominion Bank (TSX:TD) and Algonquin Power and Utilities Corp (TSX:AQN).

TD Bank has a pretty low payout ratio. At 43%, the ratio indicates that the company is not paying out even half of its earnings as dividends. TD Bank’s profits could be cut in half, and it could theoretically still keep paying its dividend. That’s not to say that it should do so: in such a scenario, a dividend cut would be wise. The point is that, with a payout ratio well below 50%, TD Bank can easily afford to pay, even raise, its dividend.

It’s quite a different story with Algonquin Power & Utilities Corp. Over the last 12 months, AQN’s payout ratio was a truly staggering 93%. Going forward, the ratio will likely be lower, because Algonquin cut its dividend payout. This is a classic case of a dividend going to high and forcing the company to reduce it in order to save money. AQN announced its dividend cut in its third quarter earnings release. The company would have had a payout ratio above 100% had it kept paying the dividend at the rate it had been. It simply had no choice but to do the cut. It would have bled cash otherwise. Unfortunately, investors who bought before the cut saw their dividend income fall and their stock prices decline. It was a rough experience.

The lesson here is simple: when investing in dividend stocks, mind the payout ratio. There’s a world of difference between a quality dividend stock and a high yield lemon.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button has positions in Toronto-Dominion Bank. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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