In my early days as an investor, I made the rookie mistake of pouring a ton of money into a stock that offered the highest dividend yield at the time. I figured that a double-digit dividend yield could help me double my money in no time, and any stock price appreciation would be icing on the cake.
I was wrong. The company slashed its dividend within a few months of my purchase, and the stock price collapsed alongside it, which taught me a critical lesson — stability is more important than growth.
A stable and sustainable dividend yield is far better than a high dividend yield, in my opinion. Long-term income-seeking investors like me simply can’t plan ahead if they can’t predict where the dividends will be next year. With that in mind, I now track two reliable metrics while picking dividend stocks.
The payout ratio is simply the ratio of the annual dividend to the company’s annual earnings. So, if a company earns £10 per share and pays a £2 dividend, the payout ratio is 20%.
A lower payout ratio is, of course, a green flag. It indicates that the management sees the potential to create more value for shareholders by holding some money back. It could also indicate that the management can maintain its dividend even if the business suffers and profits fall. It’s a cushion for risk-averse investors like me.
However, some companies pay out more in dividends than they earn every year. This could be justified if the company has plenty of cash and cash equivalents on its books to maintain a steady pace of shareholder returns. However, if the payout ratio is above 100% and the cash amount is less than three times the annual dividend amount, I steer clear.
Centrica is a prime example of this. Before it cut dividends earlier this year, the payout ratio was hovering around 110%, while the company had only £737mn in cash and cash equivalents to cover an annual dividend of over £550mn. That was clearly unsustainable and the management was forced to cut the payout.
Investors like me need to be occasionally reminded that creditors have seniority over equity investors. In other words, people who lend the company money expect to be paid before the people who hold the company’s stock.
This means a corporation is obliged to pay back the interest and principal on its loans and bonds and has no obligation to give shareholders a dividend. Most well-managed companies never have to make this difficult choice, but companies with heavy debt burdens are squeezed when profits drop or the cost of interest payments rise.
The most recent example of a company cutting its dividend to service its enormous debt is Vodafone, which slashed its dividend payout by a whopping 40% earlier this year. “The headroom has been compressed in the last six months,” said the company’s new boss, Nick Read, when justifying the dividend cut in May.
With this in mind, I like to monitor the debt-to-equity or debt coverage ratio (cash flow divided by debt obligations) to see if my dividend stock is in good shape.
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VisheshR has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.