Market corrections often occur because of macro factors. Global supply chain issues, the Russia-Ukraine war, the on/off of pandemic economic shutdowns, high inflation, rising interest rates are some factors that have triggered the current market correction.
Even veteran investors can feel uncomfortable in such a market. However, market corrections are also the best time to buy stocks.
In no way am I trying to downplay market downturns because there’s indeed heightened macro risks. But when stock prices have fallen meaningfully from a peak, it’s more reassuring to own stocks that pay you income regularly.
What are some things to look for when seeking dividend safety? There’s a lot of things to look at to determine dividend safety. We’ll discuss some of these factors immediately!
A track record of paying dividends
A track record of dividend payments. Dividend stocks that have paid safe dividends for at least five years is a good start as it covers a business cycle. Forbes wrote in a 2018 article:
A full business cycle on average is 4.7 years. The longest contraction or recession of record in the United States was the Great Depression in 1929 that lasted 43 months or 3.6 years. The second longest recession was the “Great Recession” that we all experienced in 2007 that lasted 18 months or 1.5 years.
Ideally, the dividend should be increasing over time. Shareholders would love their passive income to increase without any addition work or capital invested.
Earnings quality is also another factor that helps keep a stock’s dividend safe. Some companies, by nature of their businesses, simply have greater earnings volatility. To maintain safe dividends through business cycles, they’ll keep their payout ratios low. In contrast, dividend stocks with high earnings stability tend to have a high payout ratio. Here’s an example with Fortis (TSX:FTS)(NYSE:FTS) and Magna International (TSX:MG)(NYSE:MGA).
Payout ratio and more
The payout ratio is important. Usually, the payout ratio is calculated from dividends paid ÷ net income. TELUS Corp. (TSX:T)(NYSE:TU) trailing-12-months dividends (TTM) paid and net income are $1,087 million and $1,709 million, respectively, making its TTM payout ratio about 64%.
However, when earnings of a period do not cover dividends, dividends can still be paid from cash or retained earnings. At the end of Q1, TELUS had cash of $774 million and retained earnings of $4,350 million on its balance sheet. The latter can cover about four years of dividends.
That’s not to say that all those money are meant for dividends, because management has other uses for them, but stock investors can still see cash and retained earnings as a positive much like the case when payout ratios are meaningfully below 100%, it doesn’t necessarily mean the dividend is automatically safe.
Sometimes, investors also evaluate dividend safety with the free cash flow payout ratio which is defined as:
free cash flow payout ratio =
dividends paid ÷ (cash flow from operations – capital expenditures)
For companies with lots of depreciation expenses, it may make more sense to use cash flow instead of earnings for the payout ratio metric.
No matter which payout ratio you look at, the lower it is, the safer the dividend.
Finally, it’s always good practice to compare the payout ratio of one dividend stock to that of its peers. Companies in the same industries are exposed to similar risks so their payout ratios tend to be similar. If one is outrageously higher, investors should be alarmed.
This article mostly looked at the dividend safety aspect, but each stock is driven by an underlying business that drives the long-term returns of the stock. Additionally, stocks can get bid up by the market to ridiculously high levels that will be detrimental to total returns for investors who overpay for stocks.
If you don’t think a business is good for investment, you shouldn’t even think about buying the stock whether it pays a dividend or not. What makes a dividend stock worth investing in? That’s material for another article another day.
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Disclosure: As of writing, we own TSX:MG.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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