An Easy Way to Tell If a Stock’s Dividend is Safe
Is The Dividend Safe?
For income investors, dividend safety is of utmost importance. But determining whether a company’s payout is safe requires a lot of work. Usually, you’d have to go over its financial reports and see if it makes enough cash to cover the payout. Moreover, you should also check whether the company’s business model is sustainable and how industry dynamics may affect its future earnings power.
Doing this kind of detailed research will surely pay off in the long run. But at the same time, there might be some simple tricks that can shed light on a stock’s dividend safety. Personally, I like to take a company’s common stock dividend yield, and then compare it to the yield of its preferred shares.
Now, you are probably wondering how on earth two dividend yields can provide insight into the safety of a company’s payout.
Well, let me explain…
When we talk about a company’s dividend safety, we are usually referring to the safety of its common stock dividend. But companies may also have preferred shares, and those shares pay dividends, too.
To understand this comparison, let’s first go over the differences between common shares and preferred shares.
When you look up a company on Yahoo! Finance or Market Watch, the statistics you see—such as the stock price, market capitalization, dividend yield, and price-to-earnings ratio—are all about its common shares. To understand preferred shares, you can think of them as hybrid instruments that include properties of both common shares and bonds.
The reason is simple: Preferred stock investors have a higher claim on a company’s assets and earnings than common shareholders, but remain subordinate to bondholders.
For instance, if a company goes bankrupt and its assets are sold off, bondholders will be paid first. Then, preferred shareholders get paid. And if there’s anything left, it will go to common stock investors.
The same applies to dividends. Preferred shareholders must be paid before common shareholders. But they both remain subordinate to bondholders.
Moreover, when companies issue preferred shares, they have to specify the dividend amount—similar to a bond’s coupon payment. Management cannot cut a company’s preferred dividend when business slows down. So when you see a dividend cut in the news, chances are it refers to the dividend paid to common shareholders.
Note that preferred shareholders do not have voting rights on the company’s matters.
Still, because preferred dividends are safer than common dividends, preferred stocks should be highly sought after, right?
Well, not always. This is because while a preferred stock is considered safer, it lacks the growth potential of common stocks. If a company expands its business and generates an increasing stream of profits, those extra profits belong to the residual claimants—common shareholders. And if a company can generate higher earnings per share, the market could reward the common stock with a higher price.
Preferred stocks, on the other hand, don’t have that potential. Their payouts are fixed, and their prices tend to stay relatively stable—except maybe when interest rates change. Moreover, preferred stocks are generally not as liquid as common stocks.
Most of all, if a company is growing its profits and cash flow, management could reward common shareholders with higher dividends. And as we have seen plenty of times, dividend growth stocks can help income investors generate a tremendous amount of wealth over the long run.
Now, keep in mind that a company’s stock price is determined by the buying and selling activities in the market. Its dividend yield is calculated by dividing its annual cash payout by the stock price.
Common shares of companies with the potential of delivering safe and growing dividends are always hot commodities. As a result of high investor enthusiasm, their common stock yields tend to remain subdued.
What about their preferred shares?
Well, even for a rock-solid, fast-growing company, its preferred stock investors won’t get any of its future common stock dividend growth. At the same time, preferred shareholders also won’t benefit from a future appreciation in its common stock price.
Investing is a forward-looking business, and growth potential is a critical factor in an investor’s decision-making process. To compensate for the lack of dividend growth and share price appreciation opportunities, the preferred stock of a solid dividend-paying company usually offers a higher current yield than its common stock.
Now, let’s take a look at a few examples.
Wells Fargo & Co (NYSE:WFC) is one of the most solid financial institutions in the world. The company has been around since 1852. With total assets of approximately $1.9 trillion, it is the third-largest bank in the U.S.
Wells Fargo has an entrenched position in the banking industry. Its banking network consists of 8,200 branches and 13,000 ATMs. The company already serves approximately 70 million customers worldwide, which makes it difficult for other competitors to take away its business.
The company also pays common shareholders an increasing stream of dividends. Since 2011, WFC stock’s quarterly dividend rate has increased by a staggering 680%. (Source: “Stock Price and Dividends,” Wells Fargo & Co, last accessed June 21, 2018.)
Despite those payout increases, Wells Fargo’s common stock dividend is more than safe. Last year, the company earned a net income of $4.10 per share while paying total dividends of $1.54 per share. That translated to a conservative payout ratio of 37.6%. (Source: “Wells Fargo Reports Fourth Quarter 2017 Net Income of $6.2 Billion; Diluted EPS of $1.16,” Wells Fargo & Co, January 12, 2018.)
So, what’s the yield on Wells Fargo’s common shares?
With a quarterly dividend rate of $0.39 per share and a share price of $54.37, WFC stock has an annual yield of 2.87%.
What about its preferred shares?
Well, Wells Fargo’s preferred stock investors don’t get to enjoy the same dividend growth as its common shareholders. Moreover, because the common stock dividend is more than safe, the added level of dividend safety from preferred shares doesn’t really mean that much. Therefore, for investors to be willing to own Wells Fargo’s preferred shares, they need to be compensated in terms of current payout.
And indeed, the company’s preferred shares offer much higher yields than its common stock. For instance, Wells Fargo & Co Non-Cumulative Perpetual Class A Preferred Stock, Series J (NYSE:WFC.PRJ) pays an annualized dividend of $2.00 per share. Trading at $25.76 apiece, this Wells Fargo preferred stock offers investors a generous yield of 7.76%.
JPMorgan Chase & Co. (NYSE:JPM) serves as another great example of a dividend growth stock. The company has raised its common stock dividend every year since 2010, and just like Wells Fargo, has maintained a low payout ratio. (Source: “JPMorgan Chase Reports Fourth-Quarter 2017 Net Income of $4.2 Billion, or $1.07 Per Share,” JPMorgan Chase & Co., last accessed June 22, 2018.)
Due to the company’s growing financials and increasing common stock dividends, investors rushed toward JPM shares. Since dividend yield moves inversely to share price, the annual yield on JPMorgan Chase’s common stock stands at just 2.08% at the moment.
Again, preferred stock investors don’t have any claim on the company’s future residual profits. Therefore, they have to be compensated with a higher payout today. As you would expect, that higher payout translates to a higher yield on the company’s preferred shares. For instance, JPMorgan Chase & Co Non-Cumulative Preferred Stock, Series Y (NYSE:JPM.PRF) currently offers a yield of 5.86%.
Of course, not every company pays safe dividends. Just take a look at the number of dividend cut announcements year-to-date and you’ll see what I mean.
So, what happens when a company’s dividend isn’t safe?
Well, that’s where preferred shares start to become attractive. When a company has fairly limited resources, it has to pay the predetermined dividends on preferred shares before it can pay any dividend to common stock investors.
Moreover, if a company can’t quite generate enough cash to cover its common stock dividends, there’s not really any prospect for common stock dividend growth. In this case, income-seeking investors would much prefer to own its preferred shares rather than common shares. And the yield on its preferred stock would be lower than on its common stock.
For example, Oxford Lane Capital Corp (NASDAQ:OXLC) pays monthly dividends of $0.135 per share to its common stock investors. That translates to a jaw-dropping annual yield of 15.59%.
However, ultra-high yielders are usually not the safest bets. In the case of Oxford Lane Capital, the company earned a core net investment income of $0.31 per share in the most recent quarter, which was not enough to cover its three monthly dividend payments totaling $0.405 per share. (Source: “Oxford Lane Capital Corp. Announces Net Asset Value and Selected Financial Results as of March 31, 2018,” Oxford Lane Capital Corp, May 17, 2018.)
Moreover, the company has reduced its common stock dividend before. (Source: “Distributions,” Oxford Lane Capital Corp, last accessed June 22, 2018.)
Now, Oxford Lane Capital also has a few series of preferred shares. Because of their added dividend safety, these preferred shares offer much lower yields than the company’s common stock. For instance, Oxford Lane Capital Corp Series 2024 Term Preferred Stock (NASDAQ:OXLCM) yields just 6.64% at the current price.
I should point out that this is not the be-all and end-all method to determine a company’s dividend safety. Instead, we are trying to use two simple pieces of information—common stock yield and preferred stock yield—to backtrack investors’ decision-making process.
In other words, this simple comparison relies on the market being efficient, which is not always the case. Moreover, not all companies have preferred shares. A company may simply have one class of shares outstanding—common shares.
Therefore, we should treat the results of this comparison as a signal rather than a conclusion. So the next time you see a company with an ultra-high common yield but a much lower preferred yield, you would know that it’s time to check whether the generous common stock payout is safe.
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