The Smart Dividend Safety Score shows early warning signs of a dividend cut, before it happens.
High dividend payments are great, and rising dividend payments are better, but dividend cuts are the worst. Not only are your dividend payments reduced, but also stock values fall well ahead of the dividend cut, and often fall even further immediately following the announcement. It’s permanent capital impairment that is hard to recuperate and this is the #1 reason dividend investors stop being dividend investors.
Typically, a dividend stock that cuts its dividend first displays multiple warning signs well ahead of the actual reduction. This means that you, as a smart dividend investor, can often avoid these situations in the first place. SmartDividendStocks.com is here to protect your dividends from being slashed with our 11 Factor Dividend Safety Score.
We use the term ‘safety’ as it pertains to the ability of a company to continue paying its dividend. When using the Dividend Safety Score remember the values range from 0% to 100%, the higher the better. When investing in dividend stocks we like safety scores greater than 70%.
The image below shows the dividend safety score for IBM, now IBM has a great dividend history and is in a strong financial position, but notice that the dividend safety score is already beginning to issue warning signs. These warning signs are in the form of revenue and EBITDA growth, which have been negative for IBM as it trims its legacy business and displaces it with M&A in various other higher growth businesses. With a Dividend Safety Score of 80% we are not worried about IBM reducing its dividend, for now.
The 11 Factor Dividend Safety Score is examined below:
1. Payout ratio. We put the most weight into the dividend payout ratio as it is the single best method of determining if a company is generating sufficient income to pay its dividend. The dividend payout ratio is calculated as Dividends Per Share / Earnings Per Share and tells you what percentage of the a firms EPS is being used to fund the dividend. Lower percentages are better than higher percentages as they indicate there is headroom to either pay higher future dividends or to continue comfortably paying the existing dividend. It is smart to look at the dividend payout ratio over several years, to rule out a one-time anomaly. Dividend payout ratios higher than 100% are very worrying.
2. FCF Payout Ratio. While we place more focus on the payout ratio, we also include FCF payout in our 11 factor model as at the end of the day FCF is all that matters. Free cash flow, most commonly defined as Cash Flow from Operations (CFO) less capex is a true indicator of cash, unlike EBIT which is an income statement item and not always reflective of actual cash available to the company. Other than using FCF per share rather than earnings per share, the formula and way we assess it are the exact same as the payout ratio.
3. Interest coverage. The more debt a company has the more interest in needs to pay, interest is a burden on cash flows and mean there is less available cash to fund the dividend. Unless debt is repaid, interest income is unavoidable, unlike dividends which can be cut if necessary. The interest coverage ratio is calculated as Interest Expense / EBIT and is measured in multiples, interest coverage below 2x is very low, it means the company barely earns enough to cover its interest expenses. The higher the interest coverage ratio the better.
4. Leverage ratio. The leverage ratio is an easy way to assess how much debt a company has relative to how much earnings it has. Higher leverage ratios are bad, and often indicate a company is heading towards financial difficulties. Many companies have debt with covenants that are tied to the leverage ratio, typically on a trailing basis. Additionally, credit rating agencies look carefully at a companies leverage ratio when deciding what rating to give a company, lower credit ratings mean companies will need to pay higher interest rates to borrow money. Leverage ratios depend somewhat on what industry a company is in, a company with high infrastructure expenses and steady cash flows such as a utility company would be able to support a higher leverage ratio than one with unstable cash flows.
5. Dividend yield. A dividend yield is included in the 11 factor safety score, but only with a small weight. Investors want higher yields, but sometimes a high yield is an indicator of financial duress, and increases the chances of a cut in the future. Nonetheless, we like to see higher dividends and there are many companies that can comfortably support dividends at 5% or higher. Still when it comes to dividend safety, higher dividends are more likely to be cut so we actually include this metric as negative, which seems counter intuitive, but has proven to be a useful indicator many times.
6. Relative strength indicator. The RSI is a common tool for investors and shows how a company has performed over a recent time period. The RSI has its own score between 0 and 100, with scores closer to zero indicating the stock is oversold and scores closer to 100 indicating the stock is overbought. Typically, investors, particularly those with a value tilt, want to own stocks that have lower RSI’s indicating they may be in the bargain bin as they are out of favor. We also note that stock prices tend to under perform ahead of a dividend reduction, which means that the RSI can move into oversold territory with ease. Like the dividend yield factor, this is another counter intuitive metric, where we typically like to shop for stocks in the oversold bin, but from a dividend safety perspective, it is a potential warning sign.
7. Change in book value. Book value is a simplified way to assess a companies intrinsic value, its a snapshot of the companies asset value. Large changes in book value can signal balance sheet health, particularly if the change is the result of intangibles, which are hard to value and could be inflating book value. If book value is increasing as a result of more retained earnings then its okay. Smart dividend stocks uses a three year change in book value, which helps to capture a reasonable amount of recent history, its important to dive into this metric in more detail if you get a flag.
8. Long-term expected profit growth. Dividend growth requires earnings growth, name a dividend aristocrat that hasn’t seen earnings growth over the past twenty years. The long-term expected profit growth uses analyst consensus estimates on a companies future earnings. While we think analysts tend to overvalue companies, and have optimistic views on their long-term growth prospects, we can still use this metric as a relative gauge. The analysts are usually quite good directionally, ie. if a company is growing or shrinking.
9. Three-year FCF growth. Similar to long-term expected growth, FCF growth shows how a company has been increasing its cash flow. For the same reason FCF payout ratio is important, FCF growth is important because it indicates if a companies FCF will continue to be sufficient to meet the existing dividend and hopefully support further dividend increases in the future.
10. Three-year dividend growth. A company that has raised its dividend in the past does not mean the company will continue to raise its dividend in the future, but it is a good indicator. Companies like the dividend aristocrats that have raised their dividends for at least 20 consecutive years have a very high probability of future dividend growth, and a company that has never raised its dividend has a very low probability. We like to see a consistent trend of dividend growth, but only if it is consistent with earnings and FCF growth.
11. Three-year earnings growth. This factor is very similar to the FCF growth that we examined in #9. It shows how a companies earnings have developed over time, the trend is often, but not always, carried into the future. Companies with rising earnings can better support rising dividends.