Afternoon Review

The dividend yield on the S&P 500 is over 3 percent for the first time since 1992. However, Standard and Poor cut its estimate for 2008 dividend payments by the members of its S&P 500 index and project fourth-quarter dividends falling as much as 10 percent, which would be the worst quarterly drop in 50 years.

It is easy to get excited about the very high yields we are seeing today; however, there is a lot of pressure on balance sheets today and we could start to see many of these high dividends cut or suspended.

In spirit of this headline, this is a good opportunity to explain some basic ways to evaluate dividend payments. Our general stance is that there is no hurry to jump into a stock in fear that you are missing out on a high yield. Instead of jumping into a stock just because of a high dividend yield, investors should wait until it is more certain that the dividend payment is safe.

For example, if you were in a hurry to buy Bank of America soley for its 8 percent dividend earlier this year, then you were probably disappointed to see the dividend cut in half and the stock valuation decline.

With all of this in mind, here are a few ways to determine the health of a company's dividend.

Dividend Yield

• A company with a low dividend yield compared to the industry is either (1) a result of a high stock price that reflects the company’s impressive prospects and ability to make the dividend payment, or (2) the company cannot afford to pay a reasonable dividend because its business model is not as strong as its industry peers.
• At the same time, however, a high dividend yield can signal a sick company with a depressed share price (e.g. C, PFG, BAC, GE).

Dividend Growth

• Dividend growth is one of the simplest ways for companies to communicate the financial well-being and shareholder value. They send a clear, powerful message about future prospects and performance. Obviously double-digit dividend growth great, but something that at least surpasses inflation is nice to see.
• While a history of steady or increasing dividend is certainly reassuring, it is generally a bad practice for companies to rely on borrowings to finance those payments.
• Watch out for companies with debt-to-equity ratios greater than 60%. Higher debt levels often lead to pressure from Wall Street as well as debt-rating agencies. That, in turn, can hamper a company’s ability to pay its dividend.

Dividend Payout Ratio

• In general, the lower the payout ratio, the more secure the dividend because smaller dividends are easier to pay out.
• What is a high dividend payout ratio depends on the industry. Retail stocks tend to have ratios under 30 percent (retail is a terrible cash flow business); mature technology stocks (e.g. IBM) tend to be around 20 percent (they need cash for R&D); bank stocks are historically in the 30 to 45 percent range (the current payout ratios are not representative of historical ratios); consumer staples tend to be around 40 percent
• Anything above 45 percent or that is not the industry-norm means there may not be enough cash to weather hard times or raise the dividend.

Dividend Coverage Ratio

• This ratio is used to gauge whether earnings are sufficient to cover dividend obligations. The ratio is calculated by dividing EPS by the dividend per share.
• When coverage is getting thin, odds are that there will be a dividend cut, which usually hurts the stock price too.
• In general, a coverage ratio of 2 or 3 is considered safe. In practice, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under 1, the company is using its retained earnings from last year to pay this year’s dividend.
• At the same time, if the payout gets very high, say above 5, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Companies that raise their dividends are telling investors that business over the coming 12 months or more will be stable.

There are obviously other variables that need to be considered, but this is a great starting point for evaluating dividends...Introduction to Dividends or Dividends 101, if you will.

Because there are so many earnings reports out this week, I will forgo earnings analysis until Friday.

Peter Lazaroff, Junior Analyst