Just when you think the yields on Treasuries can’t go any lower, more bad news breaks and they plumb the bottom once again. Even with today’s tepid inflation rate, if you buy Treasuries that mature in less than 30 years, you’re essentially paying the government to hold your money. And the average stock doesn’t provide much income either: The S&P 500 currently yields just over 2 percent, well below its long-term historical average of 4.5 percent.
That’s forced income-hungry investors to pile into high-yielding stocks without always subjecting them to critical analysis. Investment publications and websites tout all sorts of intriguing high yielders, ranging from business development companies and mortgage finance firms to tanker owners and energy plays.
Stocks that pay sizable dividends can be compelling stock market investments, and in many cases, they may even be relatively safe; but the field of big yields requires careful analysis to avoid pitfalls. A company that can’t fully support a high dividend is only one bad quarter away from being trampled by the market. So the trick is to take a few simple steps to identify companies whose dividends are both attractive and sustainable.
Step 1: Determine if a company consistently earns enough to meet its dividend. Since earnings can be lumpy from quarter to quarter, it’s best to see whether a company’s full-year earnings consistently cover the payout, with sufficient money left over to finance future growth. If earnings fail to exceed the payout, the dividend probably isn’t sustainable and could be cut at the first sign of trouble.
Step 2: Look at the company’s payout ratio, or how much of its earnings are being paid out in dividends. That number is easily calculated by dividing the total dividends paid in any year by full-year earnings per share. The result will give you a good idea of how far earnings can fall before the dividend would have to be cut. For instance, a company with a payout ratio of 60 percent could see its earnings fall by 40 percent before the dividend is in real danger.
What constitutes a healthy payout ratio depends on the industry, but on average, a good upper range is between 50 percent and 70 percent. A payout ratio much higher than that is an indication that the company isn’t investing in itself, thus stifling future growth potential as well as the prospect for an eventual increase in the payout. A higher payout ratio also leaves a company little room for error in terms of earnings; one bad quarter could force it to borrow to cover the dividend or even resort to a dividend cut. If the payout ratio jumps above 100 percent, in most cases the company is either dipping into cash reserves or taking on debt in order to make its payout. In either case, that’s a red flag that the dividend is in danger of being cut.
Step 3: Look at the payment history. A consistent track record of maintaining the dividend in good times, as well as bad, indicates a dividend cut is unlikely. If a company has a long-term record of consecutive dividend increases, even though the boost in payout may have varied, it’s a strong indication that management is committed to returning cash to shareholders. While there are additional measures required to fully evaluate a dividend-paying company, these few simple steps will help you avoid the worst of the dividend traps.
