Sustainable Dividends Depend on the Payout Ratio

It’s become quite fashionable in the financial media to question the safety of almost anything paying a dividend. Of course, one can put a negative spin on practically anything. But if you’re willing to take the time to check out just one number for the companies you own, you can easily set your concerns to rest.

Roger Conrad, Big Yield Hunting

By far, the most common question subscribers of our income investment services ask is whether the dividends paid by our stock recommendations are “sustainable.” A perfectly understandable question given that many subscribers rely on dividends to meet their daily expenses and cannot afford to wake up one morning and read in the paper that monthly lifeline has been cut. 

Dividend Sustainability is More Important Than High Yield

Roger Conrad and David Dittman, co-editors of Big Yield Hunting, Investing Daily’s one-pick-per-month high-yield investment service, focus on dividend sustainability more than any other topic. As Roger repeatedly tells subscribers:

Everyone wants to buy into a big yield. The trouble is most people aren’t willing to put in the time to tell the good from the bad and ugly.

So how does one distinguish the shaky dividend vulnerable to being cut from the solid dividend primed to grow? According to Roger, it boils down to the underlying business. Always “buy the business”, not the yield:

It’s the underlying businesses that finance the dividends paid that are the clear line of demarcation, and where investors need to focus their efforts.

A Low Payout Ratio Determines Dividend Sustainability

Healthy businesses generate large amounts of cash flow and earnings. For a dividend to be sustainable, the amount paid out to subscribers must be well covered by the amount of cash coming into the business. How well the dividend is covered by actual cash is the measured by a term called the “payout ratio.” This ratio is the “one number” that Roger is talking about in the introductory quotation at the beginning of this article. Mr. Conrad describes the importance of the payout ratio this way:

The number I’m talking about will be no surprise to subscribers to any advisory I’ve contributed to over the years. It’s the payout ratio, which compares dividends to the profits that make them possible.

Generally speaking, the higher profits are relative to the dividend, the better protected that dividend is from setbacks at companies. A low payout ratio — which is the dividend as a percentage of earnings — is consequently the best possible sign that the dividend is indeed safe.

Different Ways to Calculate the Payout Ratio

The numerator of the payout ratio — dividends paid out — is easy to measure. The problem is how to measure the denominator, which refers to the cash coming in to the business. Should you use earnings or cash flow? As I wrote back in July in Not All Earnings are Created Equal: Follow the Cash, earnings and cash flow can differ markedly in any given year. The reason is that earnings are based on accrual accounting, which attempts to match a company’s assets with its liabilities in a more relevant way that demonstrates the true profitability of the company over time. There is a lot of subjective judgment and discretion in accrual accounting that can lead to earnings manipulation.

In contrast, cash flows are, well, cash and there is no room for subjectivity (absent fraud). That’s the good news. The bad news is that cash flows can be very lumpy and not indicative of the continuous liabilities they are associated with. In the long run, earnings and cash flow converge; they have to since the only difference between them is one of timing recognition of cash.

Cash Flow or Earnings?

In those cases where earnings and cash flow differ markedly, I have to go with cash flow. In the short run, a dividend’s sustainability is based on the cash in hand, not on some subjective earnings accrual number. Consequently, I would avoid companies with high current earnings and much lower cash flow. As I wrote in July, UC-Berkeley accounting professor Richard Sloan has found through a number of academic studies that companies with low accrual ratios (cash flow higher than earnings) outperform companies with high accrual ratios (earnings higher than cash flow).

One of the main reasons that a company’s cash flow may be higher than it earnings is depreciation, a non-cash charge against earnings. Under accrual accounting, companies are required to depreciate their plant and equipment every year by a certain amount, even if the usefulness of the property has not been impaired.  Consequently, many capital-intensive businesses like local telecommunications companies, energy master limited partnerships (MLPs), and real estate investment trusts (REITs) have low earnings but high cash flows.

Of course, eventually, these companies will need to replace their plant and equipment with new purchases, which will cause their cash flows to take a big hit, but MLPs and REITs engage in period public equity offerings to replenish their cash coffers and local telecommunications carriers tap the debt markets regularly. I suppose if the equity and debt markets froze up like they did in 2008 these companies could face problems, but a repeat of 2008 appears highly unlikely anytime soon.

Follow the Free Cash Flow

Consequently, the best number to use for the denominator of the payout ratio is free cash flow. The word “free” refers to the cash flow available to pay out in dividends to common stockholders once all other claims on the company’s cash flow have been paid out. The definition of free cash flow starts with cash flow from operations (net income + depreciation + amortization), adds any cash proceeds from new debt, and subtracts out:

-         Preferred dividends

-         Capital expenditures

-         Changes in working capital needs (e.g., inventory, accounts payable, accounts receivable)

-         Debt repayment

As Roger explains, the key to paying dividends is distributable cash flow (i.e., free cash flow), not earnings:

Payout ratios based on earnings per share, however, are useless when it comes to measuring dividend safety at companies that are able to pay dividends from cash flow. For these companies distributable cash flow (DCF) is the essential measurement of profits. That’s basically cash flow excluding any one-time items and after taking out debt service and maintenance capital costs. What’s left is the cash generated by the business that it can use to pay dividends, cut debt, invest in growth or buy back stock.

For companies that Roger recommends in Big Yield Hunting, he likes to see a payout ratio of less than 70%, though he is “willing to tolerate higher if the trend is moving in our favor – -i.e., earnings and cash flows are rising.”

Payout Ratio Ignorance Breeds Investment Bargains

Focusing only on earnings and ignoring free cash flows has led many income investors astray. For example, many investors have shied away from high-yield companies like Linn Energy (NasdaqGS: LINE) because their payout ratios based on earnings are above 100%. By contrast, if these investors measured payout ratios properly based on distributable cash flow, they would discover that these companies’ dividends are well covered and have payout ratios far below 100%.

The misconceptions of many investors actually are a blessing for those of us dividend investors “in the know” because it allows us to pick up these high-quality companies at bargain basement prices.

Using my Bloomberg terminal, I performed a stock screen looking for companies that pay a 6% or greater yield and have dividends higher than earnings but lower than free cash flow for three consecutive years. I came up with six companies that might be undervalued because most investors are scared of them:

Source: Bloomberg

Big Yield Hunting Has an “Income Plus” Investment Philosophy

Big Yield Hunting, the new high-yield investment service from Roger Conrad and David Dittman, takes an “income plus” approach to its recommendations. High yield alone is not enough; they demand high yield “plus” a healthy and growing business:

High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.

In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.

An “income plus” investment standard disqualifies many high-yield companies from Roger and David’s consideration. So far, Big Yield Hunting has recommended two Canadian income trusts and two telecommunications companies, all sporting very high yields that are stable and sustainable.

One of their recommendations is listed in the stock screen above. Which one is it? Give Big Yield Hunting a try and find out today!