Low interest rates have increasingly driven investors to utilize dividend-paying stocks as a means of finding cash flow. Approximately 25 percent of government bonds around the world have negative yields, meaning money is being lent to these governments, thus leading to fewer returns for the investor when bonds mature.
After Britain’s vote to leave the European Union was announced, the 10-year U.S. Treasury note yield moved down to 1.5 percent. The uncertainty created by Britain’s vote will lead the Federal Reserve to keep low interest rates for quite some time and accelerate investors’ move toward dividend-paying stocks.
[See: 7 Stocks to Buy When a Recession Hits.]
As investors stretch for yield, they should incorporate some risk control measures to make sure that they have not been stretched too far.
Income investors know that a dividend cut can be disastrous for a stock’s price. The dividend cut ends up being a double whammy with investors’ cash flow going down combined with a large decline in the price of the investment.
The traditional dividend analysis has focused on a company’s dividend payout ratio and the record of historical consecutive annual dividend payments and increases. The company’s dividend payout ratio compares the company’s accounting earnings per share to that of its dividend per share. Accounting measures are replete with accrual items, such as depreciation and amortization that can sometimes be misleading with regard to how much cash is really available to pay dividends.
While it would be nice to think that over time, accrual items balance out with actual cash flow, this is not always the case.
In order to add a margin of safety to your holdings and check the company’s potential for a future dividend cut, incorporating a cash flow stress test is helpful. This process entails the consideration of the company’s net cash on its balance sheet (cash less long-term debt) and adding that to its free cash flow (cash from operations less capital expenditures). If the total of these two combined, divided by total dividends, is not at least 1.5, then it should be a red flag and require deeper investigation.
Using Linn Energy as an example because it is rather extreme, the company was in the oil and gas production business and went public in 2006, paying a dividend of 32 cents per share on a quarterly basis. The dividend was raised to 72.5 cents per share on a quarterly basis by May 2012. This represented a compound annual growth rate of about 14.5 percent per year. The annual yield in 2013 was equivalent to about 8 percent per share. The combination of the dividend growth and yield was very attractive to income investors. If an investor would have looked at the financial statements of Linn at the end of 2012, they would have had great reason to question the sustainability of the dividend.
[See: The Perfect 10 Shares.]
At the end of 2012, Linn had about $1.2 million in cash and approximately $6.2 billion in long-term liabilities for a negative net cash flow position of more than $6 billion. The statement of cash flow showed that there was approximately $350 million provided by operating activities. The positive cash from operations would usually be a good thing. However, the company had spent $3.7 billion on capital expenditures and acquisitions, resulting in a negative free cash flow in excess of $3 billion.
A brief analysis of the financial statements showed that the dividend was being paid out of borrowed money and should have been a large red flag. The price of oil started to decline in June 2014 and Linn ended up cutting its dividend within six months. It filed bankruptcy in May, but even if oil prices had stayed in the $100-per-barrel range, the sustainability of its dividend would be highly questionable.
The major reason why companies cut their dividends generally has to do with preserving cash in the middle of downturns in demand for their products or due to excessive debt. If there is not a cushion between the amount of earnings and dividends being paid, the inevitable outcome is a dividend cut and reduction in share price.
[See: The 10 Best Materials ETFs We Could Dig Up.]
Linn and oil companies are not the only examples — it can happen to any company in any industry. As the search for cash flow continues to shift toward dividend-paying stocks, and investors continue to purchase based upon the size of the dividend yield, it is imperative to also investigate the safety of that dividend.
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Measure the Safety of Your Dividends originally appeared on usnews.com
