by Marc Lichtenfeld, Senior Analyst, Investment U
Thursday, February 17, 2011: Issue #1452
Need more money?
You’re certainly not alone. Investors of all levels are scratching around trying to find decent income to supplement their other investments – especially now that food and other costs are starting to spike.
Trouble is, with interest rates still so low, bonds, CDs and money market funds just aren’t getting the job done for many people. As a result, investors are chasing yield-bearing stocks in order to generate the income they want.
That’s fine… as long as you remember that it’s not just the amount of income generated that’s important, but also the reliability. And if you’re using the income to pay the bills, the stability of the dividend becomes even more critical.
For example, let’s assume an investor figures he’ll need $40,000 per year in dividend income to pay his mortgage and food costs. But what happens if two of the companies in his carefully structured $40,000 dividend portfolio suddenly cut their dividends and he now only earns $34,000 from it? That $6,000 shortfall means he needs to dip into his capital to make up the difference. As a result, his income in the following years will be lower, as he’s starting with a smaller investment base.
For that reason, it’s important for income investors to have a firm grasp on one key number…
The Payout Ratio: The Key to Finding Healthy Dividends
It’s called the payout ratio.
Simply put, it measures the percentage of a company’s net income that is paid out as dividends. So, if a company earns $100 million and pays out $50 million in dividends, its payout ratio is 50%.
Generally speaking, you want to see a payout ratio of less than 80%. This allows enough of a buffer zone for a company so that if its net income falls, it won’t have to cut the dividend.
So using the above example, if our $100-million net income company has a bad year and only earns $75 million the following year, it should still be able to maintain the $50 million dividend without a problem.
So how do you separate the dividend-paying contenders from the pretenders?
Scouring the Market for Healthy Income Stocks
While scouring for potentially healthy dividend-paying stocks recently, CPFL Energia (NYSE: CPL) popped up on my radar. The 97-year-old company is the largest non-government owned electricity provider in Brazil and boasts the most market share of any distributor in the country.
According to CPFL’s bylaws, it’s required to pay out at least 50% of its adjusted net income in the form of dividends. However, CPFL chooses to pay much more. In fact, it’s recently paid out 100% of net income as dividends.
Great, right? Well, it is if you want the money now. But if you’re relying on a steadier income stream, it’s a little scary because if net income falls, so will the dividend.
And that’s the key: If companies are able to grow earnings, then their dividends should be safe. But if net income falls, cash-seeking investors may have to do with a little less.
For example, companies like real estate investment trusts are required to pay all their net income in dividends. They’ll boast a higher yield, but investors should be able to handle the volatility in the dividend, as it may rise and fall, based on the company’s performance.
To isolate a few companies whose dividends could be at risk, I ran a screen of stocks with at least a 4% dividend yield, a 100% payout ratio, and where earnings per share are only expected to grow 5% or less next year.
These Companies May Be Forced to Cut Their Dividends
Here are three companies that may be forced to cut their dividends in the next year or so…
- Capstead Mortgage (NYSE: CMO): In 2010, Capstead cut its dividend from $2.24 to $1.51, trimming its payout ratio from 134% to 99%. Analysts expect Capstead to earn $1.66 in 2011 and $1.59 in 2012, making the dividend fairly unpredictable.
- Old Republic International (NYSE: ORI): This title and mortgage insurance company paid out $0.69 per share over the past 12 months, or roughly $175 million. But it only earned $30 million. This year, Old Republic is expected to earn around $160 million, still below the payout of last year. However, analysts are much more bullish for 2012, when they project earnings will double. However, if foreclosure rates don’t ease up, earnings may suffer and that could put the company’s dividend in jeopardy.
- Apollo Investment Corp. (Nasdaq: AINV): Apollo is a business development company – part of a group that typically pays at least 90% of net income as dividends. Apollo, however, is paying over 100%. In the most recent quarter, it declared a $0.28 per share dividend, despite earnings of only $0.26. In 2011, the company is expected to earn $0.99 per share, down from $1.26 and below the $1.12 projected dividend. The consensus estimate in 2012 is $1.07, also below the $1.12 threshold.
In conclusion, if you’re looking for extra income, healthy dividend-paying stocks can kick your portfolio’s returns significantly higher.
However, if you’re relying on the income over the long term, ensure that your investments will continue to pay the dividend you’ve come to expect. The payout ratio is a good place to start your research.