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Articles from The Prudent Investor
Ensuring Dividend Survivability
by George L Smyth
The continuance of a dividend is never assured, but there are a number of things the investor can examine that will offer confidence of the dividend’s survivability, or act as a red flag. We examine these metrics, look at some example companies, and link to sources where this information can be found for any company.
My wife saw an advertisement on television for a peeler. It showed someone peeling apples, pears, carrots, and on and on. As this had been one of her frustrations in the kitchen she ordered it, saying that it would change her life.
When it arrived, to be gentle, it did not exactly work as well as advertised. I tried using it myself with as little success as she had had. Today it is in the basement, in a box of things we would like to give away, but wouldn’t want to burden anyone with.
Purchasing on a promise is that we do. We buy things because they promise to help us in some way. Sometimes they do, sometimes they do not. When we purchase something with the hope that it will help us and it does not, we know that if we had had that knowledge beforehand we would not have made the purchase in the first place.
Dividend stocks are in the same category. When researching a company we look at the expectation of future growth, we look at the expectation of stability, and we look at the expectation of the dividend. As we look at financial statements there are indicators with each of these aspects, and as the first two are outside of the scope of this writing, I will focus on the dividend.
This is essential because if there are red flags implying a possible cut or removal of the dividend, then the only path forward is to value the company without this key aspect. As dividend stocks rely on this quarterly payout to attract and hold investors, valuation without the expected dividend will almost certainly mark the company as a sale.
There are a number of metrics that we can examine that will give us an indication as to what we should be looking for. We will also look at a few companies to see how they are evaluated through these metrics.
Dividend Payout Ratio
The Dividend Payout Ratio is the most commonly used metric. It is expressed as a percentage, and is found by dividing the annualized dividend per share by the earnings per share. This shows the percentage of the company’s earnings that are shared with the investor through dividends. (The opposite of this would be the retention ratio, which is the percentage of earnings that are not given to shareholders, but are retained by the company.)
The two obvious endpoints come with payout ratios less than 0% and higher than 100%. The former can happen if estimates of earnings per share for the next year are negative, meaning that the company is losing money. If the company is losing money then it has no business going further into debt by offering a dividend.
When payout ratios exceed 100% the company is making money, but more dividends than earnings are going to the shareholders. This is not a sustainable event. It is possible that a company with a long history of dividends may not want to cut or suspend the payments, and if a one-time event (lawsuit, catastrophic event, etc.) is the source of payout ratio then they may allow this to happen, but it is not a positive trend.
Payout ratios over 50% are considered to be high. From the investor’s point of view a ratio this large might be a positive event. But for the long term investor it means that the retained earnings may not be enough for the company to sufficiently invest in future growth, which could then stunt the ability of the company to increase dividends in the future.
A payout ratio over 75% trends toward the more severe end. A lack of future growth not only puts dividend increases in the future into jeopardy, but the company’s stock can drop as a result, subjecting the investor to the worst of both worlds.
The Dividend Payout Ratio is easy to find. NASDAQ.com offers the information on their website – here are links to three companies in my dividend portfolio where I have owned DRiPs an average of 20 years, MMM, Aflac and Johnson & Johnson. As can be seen from these three companies, the payout ratio is in the area of comfort.
Dividend Payout Ratio
|Johnson & Johnson||22.3%|
Cash Dividend Payout Ratio
The Cash Dividend Payout Ratio is similar to the Dividend Payout Ratio, but provides a better analysis of the sustainability of the company’s dividend. Instead of comparing dividends to earnings, the dividends are compared to cash flow, so the formula looks like this:
Cash Dividend Payout = dividends / (cash flow – capital expenditures – preferred dividends)
Preferred dividends are given to shareholders of preferred stock, which basically means that they have priority over holders of common stock. If a company is unable to pay all of their dividends then those with preferred shares are first in line to get theirs.
At first glance this may seem to be a number that would pretty much be the same as the Dividend Payout Ratio, and in a perfect world that would be the case. The difference is that earnings can be manipulated considerably easier than cash flow.
Earnings manipulation is not necessarily intentional fraud, but can be performed through legal accounting tricks that make the company appear to be more profitable than would otherwise be the case. Obviously, the more earnings a company shows, the more positively it is viewed. Examples of this manipulation could be capitalization practices, modifying the timing of operating activities, and merger-related expenses.
Cash flow is the movement of money in and out of the business. While it is possible to manipulate cash flow, it is much more difficult, so using cash flow instead of earnings in the equation can offer a more reliable number.
Cash Dividend Payout Ratio
|Johnson & Johnson||49.9%|
For these three excellent companies we see a wide range with the cash dividend payout ratios. I generally look to the guidance noted above as far as what might be considered to be high and low.
MMM’s Cash Dividend Payout Ratio appears to be on the high side, but no number should be seen in isolation. Information of this sort should not be used by itself to make a decision but should be seen in conjunction with additional information to determine its relevance. In this case MMM’s number is something to note and keep in mind while investigating other information.
MMM has increased their dividend every year since 1959, weathering seven recessions, so it would be extraordinary if they were to decide to end this streak. As this is a company that has historically placed importance on maintaining their dividend, the expectation is that they will continue to do so. We need to make sure that they actually will be able to do this.
Financial Debt Ratios
Financial debt is simply money owed by the company that is to be paid back at a future date. This could include short term debt (due within one year), long term debt, deferred revenues, pension liabilities, and many other items.
Debt is not necessarily a bad thing, after all one might go into debt to purchase a car, which in turn could make it possible for the individual to travel further for a higher paying job. The same is true with companies - properly structured debt can be used to the company’s advantage (for instance, paying 4% interest on something that offers 6% in return).
Certainly, too much debt can cause major problems. The required outflows of money limit the amount that can be used for investing back into the company, as well as dividends. Understanding the ratio of debt to certain other issues gives us an insight as to how the debt is affecting the company.
Debt to EBITDA
EBITA stands for Earnings Before Interest, Taxes, and Amortization. While EBITA is not recognized in the generally accepted accounting principles, it is a commonly used number that generally references the company’s operating profitability. Comparing the debt to profitability gives us an indication as to how much the debt is dragging on a company’s earnings.
Gurufocus.com notes that according to Joel Tillinghast (Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing) a ratio of Debt-to-EBITDA above 4 is a concern unless tangible assets cover the debt. A ratio under 1 would be considered to be very positive.
Debt to EBITDA Ratio
|Johnson & Johnson||1.24|
While MMM has the highest in this small group, the Gurufocus’s MMM page also indicates that while MMM’s debt to EBITA ratio is at a 10 year high, this number is ranked lower than 55% of the 1,843 companies in the Industrial Products category, so that should be taken into consideration.
Interestingly, Aflac and Johnson & Johnson both rank higher than 51% and 59% of the companies in the Insurance and Drug Manufacturers industries.
Debt to Assets
A comparison of debt to assets offers an indication as to how much the company’s assets are leveraged after accounting for their securities. A ratio of 0.5 or larger might be a cause for concern, but the industry in which the company fits under has much to do with this number. After all, a company that makes products to sell (like MMM) would have many assets, whereas an insurance company (like Aflac) would have considerably fewer.
While I do not consider this ratio to be as significant in terms of a dividend’s stability as the above numbers, it is valuable in that offers an insight to the degree which the company is using debt to finance its assets. In other words, a number of 0.3 means that 30% of its assets are financed through debt while 70% is owned by the shareholders.
Again, Gurufocus offers this information for MMM, Aflac and Johnson & Johnson.
Debt to Asset Ratio
|Johnson & Johnson||0.19|
Not only is MMM’s number high, but it is also high when compared to other companies in the same space. As stated above, these numbers should not be viewed by themselves, but in coordination with other numbers. When looked at together the company’s high Cash Dividend Payout, Debt to EBITDA, and Debt to Asset ratios together must make one take notice of their situation.
Delving further into the numbers, we see that MMM is currently saddled with $14 billion in debt, which even for a company of its size is substantial. Chances are that this company’s dividend is safe, but the data points noted should make holders of the stock pay closer attention to the quarterly reports. In this case I would suggest that MMM is neither a green flag nor a red flag, but more a yellow one, or caution. I have confidence that they will do what they can to continue to increase the dividend well into the future, but need to continue to monitor the situation to make sure that events do not overcome the company’s desires.
Evaluating companies to ensure that their dividend is secure is important and necessary for owners of dividend stocks and those thinking about a purchase. The company’s dividend is an essential part of the reason for owning the stock, and making sure that the dividend is retained will bring stability to one’s portfolio.
Qualified vs. Unqualified Dividends
by George L Smyth
There is a big difference between qualified and unqualified dividends, and that difference could determine whether or not one will pay taxes on them.
There is no getting around taxes. It hits us each year and each year it is a double whammy - not only does money go away, but there is frustration in simply figuring out how much is to go away. One need to somehow find ways to make an utterly dismal task palatable.
One of the few smiles possible is that of finding that one is able to take advantage of a tax break. Tax breaks are not only for millionaires and billionaires, but can be found for the small investor. That is the case when considering qualified and unqualified dividends, and that is why we need to understand the difference between the two types.
The good news is that most stock dividends fall into the category of qualified dividends. To be classified as a qualified dividend, the IRS lists three categories, each under which the dividend must fall.
- The dividends must have been paid by a U.S. corporation or a qualified foreign corporation.
There is a list of about 75 countries with which the United States has an income tax treaty. I find it interesting that in addition to Russia being included, so it the USSR (I thought they went away in the early 1990s). It is almost certain that the company in which one is investing will be covered within this group.
- The dividends are not of the type listed later under Dividends that are not qualified dividends.
This is one of those non-helpful descriptions one often gets within government documents. Generally speaking, what they are talking about are special cases, like dividends from cooperative banks and credit unions that should be reported as interest income, dividends from tax-exempt organizations, and a handful of other issues that are not common.
- You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
This is a more common situation for investors who are trading stocks more frequently than the long term investor. One must have owned the stock for a required amount of time around the ex-dividend date. In this case, the holding period starts 60 days before the ex-dividend date and ends the 60 days after. Within this 121 stretch of days, one must have owned the stock for at least 61 of those days.
As an example, one purchases shares of a company on July 5, the ex-dividend date is July 12 and the shares are sold August 8. The dividends the investor received would then not be considered qualified dividends because the shares were only owned for 34 days. If the investor had held the shares until November 1 then they would have been owned for more than 60 days within the May 13 (60 days before the ex-dividend date) – September 10 (60 days after the ex-dividend date) timeframe, thus the dividends would be considered to be qualified.
And yes, as always appears to be the case, there are exceptions to this, but they are rather uncommon.
Unqualified dividends are alternatively called common dividends. Generally speaking, these are dividends that do not fall into all of the three categories outlined above. There are some categories like REITs, employee stock options, dividends from money market accounts, and special one-time dividends that designate them in the unqualified category, but for the most part, if one is purchasing dividend stocks for the long term then almost certainly all dividends will be considered qualified.
The information for each company and mutual fund as to the total amount of dividends for the year and the amount that is qualified is listed on lines 1a and 1b on the 1099-DIV that is received at the beginning of the year.
The reason that the distinction between these two types of dividends is so important is that they are taxed differently. Nonqualified dividends are taxed at the capital gains rate. This means that there is no difference (tax-wise) between dividends that are considered nonqualified and regular income.
On the other hand, qualified dividends are taxed at a lower rate – if at all. If a single filer receives $39,375 or less in qualified dividends then those dividends are tax-free. Joint filers get to collect up to $78,750 without having to pay taxes on those dividends.
2019 Single Filer Tax Brackets
|Income Tax Bracket||Income Tax Rate||Capital Gains Rate|
|$0 – $9,700||10%||0%|
|$9,526 – $39,375||12%||0%|
|$39,376 – $39,475||12%||15%|
|$39,476 – $84,200||22%||15%|
|$84,201 – $160,725||24%||15%|
|$160,726 – $204,100||32%||15%|
|$204,101 – $434,550||35%||15%|
|$434,551 – $510,300||35%||20%|
2019 Joint Filer Tax Brackets
|Income Tax Bracket||Income Tax Rate||Capital Gains Rate|
|$0 – $19,400||10%||0%|
|$19,401 – $78,750||12%||0%|
|$78,751 – $78,950||12%||15%|
|$78,951 – $168,400||22%||15%|
|$168,401 – $321,450||24%||15%|
|$321,451 – $408,200||32%||15%|
|$408,201 – $488,850||35%||15%|
|$488,851 – $612,350||35%||20%|
The charts for the 2020 tax year are scheduled to allow for slightly higher income tax brackets, so the single filer will be able to receive up to $40,000 in dividends and joint filers will be able to receive up to $80,000 without having to pay taxes on the dividends.
As can be seen from the charts above, this makes for a very strong retirement strategy. If a single filer were to have a million dollar portfolio of dividend stocks offering an average dividend yield of 3.5%, it would result in $35,000 in dividends that would not be taxed. If the filer needed $50,000 during the year then that $15,000 of non-dividend money would be taxed at a lower rate than if the entire $50,000 came outside of dividends. Joint files would double those amounts.
It is clear that there is a huge tax advantage to ensuring that dividends are qualified. The stream of cash from qualified dividends is almost like taking money from a Roth IRA unscathed by taxes. When I start the chore of working on my taxes in March I will be grumbling until I get to the part where I report my dividends, knowing that that income will pass through without being touched by the taxman.