Before You Buy a Dividend Stock for Retirement, Check This Number

A tempting dividend yield means little if the company doesn’t generate enough earnings or cash flow to support it.

Amy Legate-Wolfe

Author Bio Amy became interested in investing in 2018 after having her first daughter. After receiving a masters degree in journalism from Western University, she became frustrated that the finance industry remained a confusing place for Canadians like her: new parents, millennials, and other young people who needed to understand their finances. Now, Amy focuses on tech companies and renewable energy for growth opportunities, coupling that with long-term investing strategies and equities. She also provides investors with a daily newsletter, Canada Stock Digest, for daily market updates. Her work can also be found at Canada's National Observer, where she writes on the business side of climate action. Before joining Motley Fool Canada, Amy wrote for major news organizations including HuffPost, CTVNews.ca, and CBC. When she’s not researching investing strategies, Amy’s time is pretty much monopolized by her two wild daughters, but in what little spare time she has she loves to do yoga, go on walks with her dog, and travel with her husband. Social Media Follow Amy on LinkedIn and Canada Stock Digest. Favorite Investment Quote “October: This is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” – Mark Twain

Published September 30, 9:00 pm EDT

A 7% dividend yield can look like retirement just got solved. But, then the dividend gets cut.

The problem isn’t that high yields are automatically dangerous. It’s that investors often start with the amount they’ll receive instead of asking whether the company can afford to keep paying it.

That’s why before I buy a dividend stock for retirement, I check one number first: the payout ratio.

data analyze research — Image source: Getty Images

Check the coverage

A payout ratio shows how much of a company’s earnings or cash flow goes toward dividends. Suppose a company earns $5 per share and pays a $2 dividend. Its payout ratio is 40%. That leaves $3 for debt repayment, expansion, acquisitions, buybacks, or simply surviving a bad year.

Now imagine the same company pays $5.50. The 110% payout ratio tells a very different story. Unless another measure better represents the business’s cash flow, the company is paying shareholders more than it’s earning.

Eventually something has to give. For retirement investors, that’s especially important. A dividend cut at 75 can hurt considerably more than a disappointing quarter at 35.

Use the right number

Payout ratios aren’t identical across every industry, however. For banks and insurers, earnings can be useful. Real estate investment trusts (REIT) often use adjusted funds from operations (FFO). Pipelines may focus on distributable cash flow (DCF). Yet the goal is the same. Compare the dividend with the cash-generating measure that best reflects the business.

A low payout ratio isn’t automatically better, either. A company distributing 10% of earnings while promising income investors a generous dividend isn’t accomplishing much. I want enough income to make the investment useful and enough retained cash to keep the business healthy. One current example is Manulife Financial (TSX: MFC).

MFC

Manulife sells insurance, retirement products, and wealth-management services across Canada, Asia, and the United States. That mix gives it several sources of earnings, while Asia remains an important long-term growth business.

Second-quarter core earnings climbed 12% year over year to $1.9 billion. Core earnings per share (EPS) increased 16% to $1.09. Meanwhile, Manulife’s quarterly dividend is $0.49 per share. Divide $0.49 by $1.09, and the quarterly core dividend payout ratio works out to roughly 44%.

That’s close to the top of Manulife’s own medium-term target range of 35% to 45%, but earnings are currently supporting the payment. That’s the number I’d care about before getting excited by the yield.

Income with room

At $61.53, Manulife’s $1.94 annualized dividend produces a yield around 3.2%. It won’t turn a modest retirement account into an instant passive-income machine. However, it does offer something I prefer, and that’s a dividend backed by growing core earnings.

Manulife has also been reducing risk elsewhere in the business. In August, it announced a $3.2 billion reinsurance transaction covering part of its legacy U.S. long-term-care business, the third such transaction in three years.

Management says the three transactions together will reduce its legacy long-term-care reserves by about 24%. That doesn’t remove insurance risk, but it reduces exposure to one of Manulife’s more troublesome legacy businesses.

Considerations

The stock itself isn’t particularly cheap. At $61.53 at writing, Manulife trades around 12.8 times forward earnings and sits close to its 52-week high of $63.58. Insurance earnings can also move with markets, claims, interest rates, policyholder behaviour, and assumptions about future liabilities.

That’s why I’d consider MFC as one part of a diversified group of Canadian dividend stocks, not an entire retirement plan. I’d also keep checking the payout ratio after buying. Dividend safety isn’t something investors verify once and file away for 20 years.

Bottom line

Yield tells you how much income you’re getting at today’s share price. That said, the payout ratio gives you a better idea of what the company is sacrificing to provide it.

For Manulife, a roughly 44% core payout ratio currently leaves earnings available for growth, capital needs, and other shareholder returns while supporting a 3.2% yield.

That’s the combination I’d rather take into retirement. A smaller dividend that keeps growing can become far more useful than a giant one that eventually disappears.