Four Metrics for Identifying Risky Dividend Stocks

High dividend yields offer the promise of greater income. While there is a benefit to getting juicier dividends, high yields can be a warning sign.

Investors collectively demand higher yields when they perceive higher levels of risk. The high yield is viewed as compensation for the chance that the current stream of dividend income will not continue in the future. Higher yields are also compensation for the risk of the company encountering financial difficulties, thereby leading to a falling stock price.

This creates a paradox for dividend-focused investors: The highest yields might not represent the best opportunities, but rather the riskiest ones.

We can see this relationship between yield and risk in AAII’s Dividend Strength Grade. As dividend strength weakens, yields go up. (Dividend strength is one of three pillars used in AAII Dividend Investing to help assess whether a stock is attractive or not from a dividend standpoint. The other two pillars are dividend valuation and dividend growth. All dividend-paying stocks are assigned grades based on each of these three pillars.)

This week’s chart is one I prepared for a webinar that AAII will be co-hosting with BetterInvesting on August 26. As you can see, the median yield progressively rises as the Dividend Strength Grade worsens. Companies with a grade of A (very strong) have a median yield of just 1.2%. Companies with a grade of F (very weak) have a median yield of 4.3%.

The Dividend Strength Grade considers four key metrics to determine whether the dividend is secure and whether the company has the financial ability to grow it.

• Earnings payout ratio compared to its sector median: The lower the payout ratio, the more secure the dividend moving forward. As the payout ratio rises, the company runs the risk of having to cut its dividend if it has a cash shortfall.
• The ratio of total liabilities to total assets for latest fiscal quarter: This is also known as the debt-to-assets ratio. The higher the percentage, the greater the potential for the company to violate its debt covenants and be forced to suspend its dividend.
• Times interest earned: This metric determines how easily a (nonfinancial) company can pay its interest expenses on outstanding debt with operating earnings. The larger and more stable the ratio, the lower the risk of the company defaulting on its debt and the more able a company is to pay dividends. (Times interest earned is often referred to as the interest coverage ratio.)
• Dividend sustainability: This metric looks back over a seven-year history to see how many times a company has cut its dividend. A company should not have made any cuts to its dividend over the past seven years.

We consider sector medians for the earnings payout ratio and the times interest earned ratio because both can vary considerably. Utilities companies, for instance, pay out more of their earnings as dividends than financials companies do.

Both the payout ratio and liabilities-to-assets ratio can be found in the Ratios tab of AAII’s Stock Evaluator. (To access the Stock Evaluator, just type a stock’s ticker symbol or company name into the search box at the top-left corner of most pages on AAII.com.) The times interest earned ratio can be calculated easily using the data in the company’s financial statements. You can also look at the Financials tab of the Stock Evaluator to see whether the dividend was cut over the past seven years.

Conducting this simple analysis will give you insights into whether the dividend is secure or at risk of being cut. If the latter, then the high yield is a warning to stay away.