Successful companies usually have money left over after they have funded their everyday operations and satisfied immediate debt and fee obligations. They have to decide what to do with the excess cash. Sure, the safest option is to just keep it in the bank as a cash deposit or money market deposit. But those low-risk deposits don’t earn anything.

Alternatively, a company can reinvest the money into itself to try to grow. It could also look for acquisitions. It can invest in financial markets, such as bonds and stocks. These are all types of investments in one form or another. Just like you and I, companies want their money to earn money.

Rewarding Shareholders

A company can decide to use some of the excess cash to reward their shareholders via share repurchases and/or dividends. For share repurchases, a company will typically announce its intention to repurchase a certain amount (say, $500 million) of stock and will buy the stock over the ensuing months behind the scenes. It will have discretion when to buy and how much to buy each time.

In the case of dividend, companies have less flexibility. This is especially true in the U.S., where investors are used to receiving a regular quarterly dividend.

For companies that have an established dividend policy, there is pressure to keep increasing the dividend. At the very least, they need to keep the dividend level unchanged.

Dividend Cut: Bad for Everyone

Any dividend cut will likely result in a market selloff of the company’s stock. This makes sense. A growing dividend implies that the company is generating more and more cash to support the growing dividend obligation. On the other hand, when a company has to cut its dividend, it implies that the company is not in good financial shape. Besides, for income investors looking for high dividend income, a dividend cut is very much a valid reason to move on.

Indeed, if you happen to own a stock that undergoes a negative dividend event, you will not only end up receiving less dividend (if you continue to hold on to the stock), the value of your stock also will take a hit. It’s a double whammy. Thus, it’s important to keep an eye on the financial situation of the companies you are invested in.

Comparing Dividend to Earnings

A commonly cited metric used to analyze the sustainability of the dividend is the payout ratio. It’s calculated by dividing dividend paid per share by earnings per share (EPS).

If company XYZ earned $1 per share this quarter and pays $0.70 a share, the payout ratio would be 70%. Analyzing what percent of the profit is being paid out as dividend does make sense. Simply put, if a company isn’t making money, it won’t have money to pay out to shareholders.

However, the payout ratio isn’t the end all be all. There are potential problems with it.

For example, let’s take a look at Realty REIT (NYSE: O), a real estate investment trust (REIT) that’s one of the most consistent dividend payers out there. It actually pays a dividend every month. In 2020, despite the lockdown that shut down businesses across the nation, Realty REIT’s property portfolio held up and the REIT actually increased its dividend. It paid out $2.80 per unit (share) for the year, but its 2020 EPS was only $1.15!

How can a company pay out more than twice its profit? Surely, something’s amiss.

Problems With Analyzing Earnings Alone

You see, REITs own many properties, and every accounting period, they book a lot of depreciation expense, which reduces earnings in a major way. But depreciation is a non-cash expense. While the depreciation reduces earnings and thus reduces taxes (a good thing), the amount of cash on hand does not change. This is why REITs report a special metric called funds from operations (FFO) that better reflects their cash position.

Realty REIT’s 2020 FFO was $3.31, which more than adequately covers the $2.80 dividend. And it’s a much more appropriate measure in terms of analyzing the REIT’s ability to sustain its dividend than the $1.15 EPS.

Even for other types of companies that don’t have a ton of depreciation expense, earnings can be misleading. This is because management has the freedom to make decisions that can directly impact earnings. For a given period, it’s possible to “massage” earnings in order to report higher or lower profits depending on management’s objective. Examples of where earnings can be massaged include the timing of revenue recognition and method of inventory accounting. It’s dishonest, but not illegal.

Cash Flow Paints Clearer Picture

Even if management isn’t trying to mislead, there still could be many non-cash items in earnings that muddle up the picture. This doesn’t mean comparing the earnings payout ratio is a useless measure. Rather it means that you have to look at more than only earnings.

It’s more difficult, but not impossible, to do “creative accounting” with cash flow than earnings. In particular, pay attention to a company’s operating cash flow (OCF). Cash generated from everyday business operations tends to be the most dependable source of recurring cash flow. Look at trends and compare the OCF to earnings. Ideally, both earnings and OCF are growing consistently. If earnings are consistently significantly higher than OCF or if OCF is falling without a good explanation, beware.

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