All Hail Dividend Stocks!

Dividend stocks are all the rage in the Dow Jones newsroom, with Barron’s cover story (10 for the Money) and the Wall Street Journal (Shop for Dividends in This Aging Bull Market) both championing “safe” dividend paying stocks.

This should be no surprise. The Fed’s zero-interest-rate-policy (ZIRP) is forcing investors and savers out of money-market funds and CD as the yields of those cash equivalents are virtually zero. Meanwhile, longer-term bonds sport higher yields, but leave investors exposed to inflation.
The common thesis among news articles like the ones above is quite simple. Low-quality stocks have been driving the current rally, but high-quality stocks will drive the second phase of the rally. And if the rally fades, they offer downside protection through their income.

But before you start scouring the market for yield, remember that higher yield often involves higher risk.

Here are some of the tools Acropolis uses to evaluate a company’s dividend.

Dividend Yield (Dividends per Share/Share Price)
Low yield compared to industry peers 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 a strong as its industry peers.
   

At the same time, however, a higher dividend yield can signal a sick company with a depressed share price.

Dividend Growth
A company that increases its dividend sends a powerful message about future prospects and performance. A history of steady or increasing dividend payments often signals financial well-being and shareholder value. Double-digit growth rates are preferred, but a growth rate that at least exceeds inflation is sufficient.

Of course, dividend growth shouldn’t come at all costs. We generally frown upon companies that rely on borrowings to finance dividend payments. Watch out for companies with a debt-to-equity ratio greater than 60% since debt levels can hamper a company’s ability to pay its dividend (see financial crisis of 2008).


Dividend Payout Ratio (Dividends/Net Income) or (Dividends per Share/EPS)
In general, a lower payout ratio signals a more secure the dividend because smaller dividends are easier to pay out. A high payout ratio often means there may not be enough cash to weather hard times or raise the dividend.

However, different industries have different payout trends. For example, retail stocks tend to have ratios less than 30% and telecom stocks tend to payout more than 70% of profits. As a result, a company’s payout ratio should be compared to that of its industry peers to determine if it is high or low.


Dividend Coverage Ratio (EPS/Dividends per Share )
Dividend coverage ratio gauges whether earnings are sufficient to cover dividend obligations. In general, a coverage ratio of 2 to 3 is considered safe.

In practice, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5. If the ratio is under 1, then the company is using its retained earnings from last year to pay this year’s dividend.

If the coverage is too high, say above 5, then investors should question whether management is withholding excess earnings or not paying enough cash to shareholders.

--

Peter J. Lazaroff, Investment Analyst