3 Ways to Decide Whether a Dividend Is "Safe"

By Markets Fool.com

Dividend stocks have been shown to outperform non-dividend-paying peers, but not all dividend-paying stocks are created equal. Some dividend-paying stocks are downright risky, especially if they run afoul of these three metrics our Motley Fool contributors use to gauge whether a dividend is safe.

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We should never decide that a dividend is safe based juston a single metric. But a great metric to start with is the payout ratio, which divides the annual dividends per share by the annual earnings per share, or EPS. Consider, for example,Ford Motor Company , which recently raised its quarterly dividend by20%, from$0.125to $0.15. Thus, its annual dividend payout is now $0.60. For its annual EPS, we'll look at its trailing 12 months of EPS, which is $1.53. So divide $0.60 by $1.53 and you'll get a payout ratio of 0.39, or 39%.

That payout ratio tells us that right now Ford is paying out 39% of its earnings in the form of dividends -- and it clearly has plenty of room for further dividend increases. Investors who favor dividend-paying stocks want their holdings' dividends not only to be sustainable and "safe," but also to grow over time. Low payout ratios are good, but a verylow ratio suggests that the company could be more generous when it comes to dividends. Of course, it's worth remembering that companies might want to do other things with their earnings, such as pay down debt, buy other companies, reinvest in the company to fuel growth, and buy back shares (which can also reward shareholders).

On the other hand, a payout ratio can be uncomfortably high, too. If it's 85% or 90%, for example, that reflects a company paying out most of its earnings in dividends, with little room for growth. It's also a bit risky, because if the company's business goes through a rough period, its earnings might end up lower than its dividend obligations. You'll sometimes see a payout ratio above 100%. That company is already paying out more than it's generating in earnings, so that's a definite red flag. It's not guaranteed doom, as earnings can rise in future quarters, but it's cause for concern and further research.

Dan Caplinger
As Selena notes, payout ratios are a great first step in assessing the safety of a dividend. But many companies seem to sustain dividend rates well above what their earnings would suggest is possible over the long run. For instance, rural telecom companyWindstream Holdings has a payout ratio of about 400%, paying out almost four times its annual earnings in dividends each year.

The explanation is simple, though: Payout ratios are based on accounting earnings, which don't always reflect actual cash flow. To address this disparity, some investors prefer to look atpayout ratiosbased on free cash flow. Rather than taking net income into account, this alternative metric starts with the amount of operating cash the business generates and then subtracts any money needed for capital expenditures. What remains is free cash flow, and by comparing it to the amount of money the company pays in dividends, you can get a better sense of whether the company can cover dividend payments from operating cash without having to borrow from outside sources. Using the free cash flow payout ratio is most common in industries where there are substantial non-cash accounting expenses, such as depreciation, that create large disparities between net income and free cash flow. When earnings-based payout ratios look suspect, checking the free cash flow payout ratio can go a long way toward explaining the situation more clearly.

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The best and safest dividends are those that can be paid even if a company's growth turns negative. After all, recessions and downturns are certain to happen, and slowing growth at the sales line ultimately has a proportionally larger impact at the bottom line.

This concept is called "operating leverage" -- that is, how much a company's income will jump up and down based on a small increase or decrease in sales.

Retailers tend to have a lot of operating leverage, and among them, car dealerships have some of the highest. TakeCarMax as an example. In 2010, it sold just under $7.5 billion of used cars and earned only $101 million in operating income that year. In the past 12 months, however, it sold $13.8 billion in used cars and generated operating income of $592 million. Because of its operating leverage, the company earned nearly six times more in operating income on a much smaller increasein revenue during the recent period.

CarMax doesn't currently pay a dividend and probably won't for some time, if at all. Instead, it chooses to return cash to shareholders through buybacks. The reason may just be its operating leverage. In a downturn, CarMax's income will fall much faster than its sales. In a growing market for used cars, its profits will rise much faster than its sales. Car sales are cyclical, therefore so are the company's profits. Thus, a promise to pay a consistent dividend may just turn out to be a promise it can't keep.

I'd encourage any investor to look at the operating leverages of the businesses in which they invest. One good thing that can come out of a financial crisis is that investors can see how companies performed in a bad economic climate simply by looking back through a few years of financial filings.

The article 3 Ways to Decide Whether a Dividend Is "Safe" originally appeared on Fool.com.

Dan Caplinger and Selena Maranjian own shares of Ford. Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends and owns shares of CarMax and Ford. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.