EP39: Part 1 - How do you know if the dividend is safe?

Imagine this: you're watching your investments grow, but then your dividend gets cut. Panic sets in. What does this mean? How will it affect your financial future? Join me in this episode of the Simply Investing Dividend Podcast as I dissect and demystify the world of dividends: from the importance of dividends to investors, indicators of a dividend cut, to the implications of a dividend reduction. In doing so, I highlight the often overlooked payout ratio and explain how to calculate dividend yields using real-life examples. 

I cover the following topics in this episode:
- What are dividends?
- 2 reasons why dividends are important to you
- What happens to your investment when a dividend is cut?
- What is the payout ratio?

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Transcript

Speaker 1: 0:00

Before you invest in any dividend stock, how do you know or how do you ensure that the dividend won't get reduced or eliminated? Hi, my name is Kanwal Sarai and welcome to the Simply Investing Dividend Podcast. In this episode, we're going to look and see if the dividend is safe. Before you invest any of your money into a dividend stock, you want to make sure that the dividend is going to be safe and it's going to be around for a very long time. So in part one of this episode, we're going to cover, first of all, what are dividends. Then we'll take a look at the two reasons why dividends are important to you as an investor. After that, we're going to look at what happens to your investment when a dividend is cut. And the last topic in this episode we're going to take a look at the payout ratio. And then we'll continue with part two in our next episode, where I'm going to look at the history of companies paying dividends. So we're going to review that. Then I'm going to show you how to look for earnings and dividend growth, and then we'll look at what is a dividend trap and how to avoid it.

Speaker 1: 1:21

So, first off, let's get started with part one in this episode and what are dividends? A lot of you may already know what that is. I've covered that many times in a lot of previous episodes. But for those of you that are new, stick around. We're just going to spend a couple of minutes looking at what are dividends. So a dividend is essentially the company sharing its profits with you, the shareholder. So let's say we're looking at a company here that's paying a dividend of $1 per share And that's an annual dividend, and you own a thousand shares in this company. Then you will earn $1,000 every year for as long as you own those shares and as long as the company continues to pay the dividend of $1 per share. Now you can spend that money if you wish. The dividends are deposited directly as cash into your trading account. So, like I said, you can spend the money if you wish or you can reinvest them, and as a dividend investor, we prefer to take those dividends and invest them into other stocks that also pay dividends And over time that's how you grow your investments. Now keep in mind here in this example we talked about a dividend of $1 per share. As long as you own those shares, you will receive those dividends, regardless of the stock price. Stock prices go up and down all the time. Stock markets go up and down all the time. But if a company is paying a dividend of $1 per share and you own those shares, they will pay you those dividends and that cash. And we're going to take a look later on in this episode of what happens if a company reduces its dividend or eliminates its dividend. So we'll look at that in a couple of minutes later on.

Speaker 1: 3:14

Now let's move on to our second topic in this episode The two reasons why dividends are important to you as a dividend investor. So there's two things. Number one is going to be income. Dividends provide you with income. Okay, so let's look at that first. Secondly is margin of safety, but we'll look at that later. We're going to start off with income dividend income.

Speaker 1: 3:39

So in this example, we're going to take a look at a real-life example of a company Royal Bank of Canada, rbc. This is the largest bank in Canada was founded in 1864. They serve over 17 million clients. They have over 94,000 employees. They operate in Canada and in 36 other countries, including the US, and RBC, the Royal Bank of Canada has over 1.9 trillion dollars of assets under management, so they are a fairly large bank. So if we take a look at this on the screen, you can see what a typical stock quote looks like. So I got this from Yahoo Finance, you can get it from Google Finance or MSN Money or CNBC any of the hundreds of sites that give you stock quotes. So you just type in the company name or the stock symbol, which is our Y, and you can see that the share price as of this recording is $126.

Speaker 1: 4:39

But we're going to focus on in this example. We want to look at the dividend and the dividend yield specifically. So it's really simple. This is not complicated math. The dividend yield is your annual dividend Divided by the share price. So in this example we can see that the company is paying an annual dividend of $5.40. We divide that by the share price, $126, we express that as a percentage. You can see that the dividend yield is 4.32 percent today and we can see it in the screenshot right there In the stock quote. It will tell you automatically what is the dividend yield if you were to buy the stock at this price. Now, if the stock price changes, the dividend yield is going to change. If the annual dividend changes, then that's also going to change the yield. But as of right now, what we see on the screen, we can see the dividend yield is 4.32 percent. And what does that mean? That means that is a return on your investment while you hold on to those shares. And again, the stock price can go up and down, but as long as you bought the shares at this price in this example, $126 and the company continues to pay the dividend, you will earn 4.32 percent every year.

Speaker 1: 5:58

Let's take a look at a very quick example. So if you were to invest $25,000 in this company, in this stock, then 4.32 percent of that is exactly $1,080. So you would receive $1,080 every single year, as long as you own those shares and as long as the company continues to pay the dividend. So that's not bad. But let's take a look at a more specific example. We're going to stick with RBC and we're going to start in the year 2010. So we're going back a couple of years and imagine you had bought a hundred shares back in 2010 and At that time the share price was $50 and 40 cents. So $50 and 40 cents to buy one share. And In this example we're going to say you bought a hundred shares, so your total investment in RBC was $5,040, so roughly $5,000. We're just going to round that off, so you can see that in 2010 and you can see it up on the screen the company was paying a dividend of $2 per share. Okay, so you can see that the dividend yield and And again, just a quick reminder, we take the dividend at the time divided by the stock price, which is your purchase price at that time. So $2 divided by $50,040, you can see that the dividend yield was 3.97%. Now, at the end of the day, what that means is your annual dividends was $200. Right, we take the $2 dividend per share, multiply that by the hundred shares that you bought and you receive $200 in dividends.

Speaker 1: 7:51

The following year, the company increased its dividend So you can see here up on the screen as soon as we can get it up here the dividend went to $2.08. So the yield went up to 4.13% And the dividends you received was $208 now. So not a huge increase, but it's still an increase nevertheless. The year after that, in 2012, the company increased the dividend again, and then you received more dividends that year. In fact, the company has increased its dividend every single year, and you can see it up on the screen.

Speaker 1: 8:29

We have all of the dividends listed out. We have all of the dividend yield listed out since 2010. And I'm gonna jump to the current 2023. As of this recording, the annual dividend is $5.40. So if we take the current dividend today divided by your purchase price, which was $50.40, you can see that your dividend yield is a little over 10%. So 10.71% return every single year. That means this year you will receive $540 in dividends from this company. So that's a big increase from 2010, when you were only receiving $200 that year in dividends. So now you're making a lot more.

Speaker 1: 9:13

Now, if we add up all the dividends received since 2010, and remember you bought 100 shares you can see that you would have received over $4,830 in dividends. Now that's very close to your initial investment, which was roughly $5,000. And the way things are going, we can assume that within the next eight to 12 months that the total dividends received from this investment will exceed your initial investment, which is incredible. Right now, let's summarize just some of the numbers here. So the total investment you can see on the screen was roughly $5,000. You can see the stock purchase price was $50.40. Since today, the stock is trading at over $126, the stock price appreciation alone is 151%. But it gets even better because now we're gonna add on the dividends. So you can see that when we add all the dividends in that you've received over the years, you can see that your total investment has grown by 247%. Okay, so now we can see that the total investment today, if anybody's interested, the $5,000 initial investment today is worth over $17,400.

Speaker 1: 10:43

Okay, now we're gonna look at number two. Remember I said there was two reasons why dividends are important to you. So one was income, and we just saw that Great source of income. It starts off small, but over time it grows. Every time the company increases the dividend, your income grows And in the example we just saw, the income over time will match and eventually exceed your total investment in that company.

Speaker 1: 11:10

Okay, so now we're gonna look at number two, which is margin of safety. So we're gonna stick with our same example with RBC. Same example 100 shares bought in 2010. Total investment was $5,000. You can see on the graph here over time, every time the company increases the dividend, your risk goes down. Okay, now let's see how that looks like Again.

Speaker 1: 11:37

This is the same slide that we I just showed you earlier, because over time the dividends went up. That was more money in your pocket. Dividends are deposited as cash into your trading account. So you can see that over time, the dividends and in this example we can see that the dividends, total dividends received will equal and then exceed your total initial investment. And so that is your margin of safety there, because at that point, once you've made your money back in dividends, then you don't really care, or you're you're not as fearful when the stock price drops, like in this example. Right, the stock price is at $126. This investor who invested in 2010 in RBC do they really care if the stock price drops to $120 or $100 or even $95? Not really because, like I said, within the next six to eight months, 12 months, they will make all of their money back in dividends and then after that it is just pure profit, the return on your investment, and we can see the dividend yield is now in the double digits and every time the company increases the dividend, the dividend yield is going to go up.

Speaker 1: 13:01

So those are the two main reasons why dividends are important to you. Number one is income and number two is that they provide a margin of safety. Now, in the unlikely event, like I said, this is RBC. This is a huge company. It's a huge bank, largest bank in Canada. If they were to go bankrupt and the shares were worth zero, well, you still didn't lose any money, right? The dividends that you've received since 2010 are almost about $5,000, and your initial investment was $5,000. So the worst case scenario is if a company goes bankrupt and the shares are worth zero. Well, if you've held on to it long enough and the company was paying enough dividends and you have a diversified portfolio, right, that's a different topic. But you can ensure that you have a margin of safety there. The dividends provide you with a margin of safety. Without the dividends, you're only hoping for the stock price to go up and then, if the stock price does crash, or the worst case scenario, as a company goes bankrupt, well then you lose your entire investment in that company. So that's why margin of safety is very important to us.

Speaker 1: 14:12

Now let's move on to our third topic in this episode. So what happens to your investment if there is a dividend cut? The dividend is either reduced or eliminated. So let's see what that looks like. So we're gonna put up a real simple example up on the screen Again. Dividend yield is your dividend divided by the share price. So in this example, let's say the dividend is a dollar per share and the share price happens to be $20, well then your dividend yield is gonna be 5%. That's the return on your investment while you hold on to those shares.

Speaker 1: 14:46

Now let's see what happens if the company cuts the dividend from $1 to 50 cents. So now we take 50 cents divided by the share price and you can see that the yield now is is two and a half percent. What happens if the company cuts the dividend again to maybe 10 cents? So now we take that divided by 20, you can see the yield is now 0.5. And if the company is to eliminate the dividend altogether, well then the dividend yield is zero. So you can see what's happening here. You can see it on the screen.

Speaker 1: 15:19

It's very clear every time the company reduces the dividend, what's happening to the dividend yield? the dividend yield is dropping, which means, of course, there's less money in your pocket. If the company was paying a dividend of $1 and now all of a sudden they cut the dividend in half, well, your dividend income from this company is gonna be cut in half. So you can see that clearly. And so what this means. Of course I just said this before. But if the dividend is eliminated, your dividend income from that stock goes to zero, because now you're not gonna be receiving any more dividends. The dividend's gone. Now if the dividend is reduced, like I said before, your dividend income is also gonna get reduced.

Speaker 1: 16:05

So any of the above actions will cause a drop in the stock price. Why? Why does that happen? Well, let's take a look at our example we just looked at. If the dividend yield is so low so let's say in this example, 0.5 percent investors don't want to take that risk. They would take their money and just put in a term deposit where you can make three, four, five percent, or put it even in a checking account that will pay you one percent. Right, if that's any. Interest rates are going up, so maybe that's a possibility. But if you can put your as an investor, if you can put your money in a low risk investment and get a higher return, then why would you risk your money in dividends with a very small dividend yield? So when that happens, investors will shy away from the stock. They might even sell the stock if the dividend gets cut. So any of those things. When that happens, then the stock price is going to come down because there's less demand for that stock.

Speaker 1: 17:19

So, yeah, again, what happens when a dividend reduction is announced? So this is important. This is even before the dividend reduction takes place. The company will first announce it through a press release. It'll go out in the media and they'll say we are planning on such and such a date, or effective immediately, we are reducing the dividend or cutting the dividend. So let's take a look at what happens. Here's the stock price for Boeing, and Boeing, in March of 2020, cut the dividend to zero because of COVID and everything else that was happening. They said we're not going to pay a dividend anymore And you can see the stock price. You can see it right on the screen, in the middle of the screen, and you can see the stock price is up here. And as soon as they announced it, the stock price came down. So that's not good news for investors, right? Of course we want the dividend, but we also don't want to see the stock price tank.

Speaker 1: 18:19

So let's take a deeper look at one more example, and we're going to take a look at six flags. Okay, so let's say you bought 117 shares back in 2014. And the share price back then was $42.55. So a total investment of $4,978. So again, roughly about 5,000. Just trying to keep it the same as the previous example. So a $5,000 investment in six flags. And you can see here that in 2014, the dividend was $1.93. Then the company raised it the following year to 214. And they kept raising the dividend until 2019. So at 2019, you can see it on the screen the dividend was $3.29.

Speaker 1: 19:05

What happened after that? The following year, the company cut the dividend to 25 cents And the year after that they eliminated the dividend. And so you can see, in 2021, 2022, and 2023, the dividend was zero. The company did not pay a dividend to any investors And when that happens, you can see it up on the screen the dividend yield was zero. So if we add up all the dividends since 2014, you can see that it only comes out to $1,845. So the numbers don't look as great as they did when we were looking at the previous example with the Royal Bank of Canada.

Speaker 1: 19:48

So if we summarize it here, we started with a total investment of about $5,000. You can see the purchase price was $42 at the time. The stock price today is $26. And so the stock price. If you just look at the price alone has gone down 38% And that's a significant drop in the stock price. Now, if you add the dividends, there was roughly about $1,800 in dividends. So that helps us a bit. It doesn't make our 38% negative 38% look as bad And then so if you include the dividends, then we're only looking at a loss of 1%, so a negative 1% return. So at the end of the day, after 2014, your roughly $5,000 investment is worth pretty much a little under $5,000, right, $4,932. So you didn't make any money, and the fact that the dividend was reduced and then it was cut didn't help us as dividend investors.

Speaker 1: 20:52

So now, is there an early warning signal that can tell us that a dividend cut or dividend reduction is coming? Because that would be helpful. If there's an early warning sign that we could look at, then we can make a better decision if we want to invest in that company or not. And the answer is yes, there is. There is an early warning sign that we could take a look at, and that is the payout ratio. So let's take a look at that. That's the last topic in this episode, so let's finish that off with looking at the payout ratio. The payout ratio again, real simple. This time we take the annual dividend and we divide it by the earnings per share or the EPS, and the earnings per share is the profits of how much money the company made, and you divide that by the number of outstanding shares and you end up with earnings per share.

Speaker 1: 21:47

So we're going to look at an example of two companies in the same industry restaurants. So the first company we're going to look at is Restaurant Brands International. They own a number of brands out there, a number of restaurants Tim Hortons, burger King, popeyes, restaurants like that The stock symbol is QSR. And then the second company is Wendy's, another restaurant, and the stock symbol is WEN. So let's start with Restaurant Brands International.

Speaker 1: 22:22

Again, we're looking at the stock quote here, but we're interested in looking at the annual dividend and the earnings per share. So we can see in the screenshot right there, the annual dividend is $2.20. And the company made $3.26 profit. So that's good. They made $3.26 in profit, remember, per share, and they gave back to the shareholders $2.20 in dividends. So what do they do with the rest of the money? They kept it. They reinvested back into the business to grow the business. So if we want to calculate the payout ratio, take the dividend $2.20, divided by the EPS, which is $3.26. Express that as a percentage, you can see it's 67%. So 67% of what the company made was paid out to the shareholders.

Speaker 1: 23:23

So now let's take a look at the next company, wendy's. So again we're looking at the stock quote here. Wendy's Only earned 84 cents. That's EPS earnings per share. The company only earned 84 cents, but they turn around and paid the shareholders $1 in dividends. Now keep in mind, just to be clear, this is an annual dividend. The earnings per share is the TTM, the trailing 12 months, but still this is a good indicator. It's not the perfect indicator, but it's a good indicator.

Speaker 1: 23:59

So here you can see that the companies will eventually pay the shareholders more than what they earned, and you can see the payout ratio is over 100%. It's 119%. Now the company could do two things here. They could increase their earnings before the end of the year or they can reduce the dividend, and as dividend investors we don't want to see the dividend go down, because that is the income that comes right into our pocket. So if we look at these two companies side by side, all things considered equal Okay, we're not going to look at for now. We're not going to look at the debt, we're not going to look at the P ratio, the book value and all other other stuff. All things considered equal. If you were looking at these two companies and just looking at the payout ratio and comparing the two, then restaurant brands is probably going to be a better investment, whereas with Wendy's, the payout ratio is over 119%. We don't know if the company's going to have to reduce its dividend in the future. Okay, so that's a quick way to take a look at the payout ratio And it's one of the early warning signs that can tell us if the dividend might be at risk.

Speaker 1: 25:18

Now here's another sign, in case you missed it. So we're looking back at the six flags numbers up on the screen And you can see that in 2019, the dividend was $3.29. The following year, the dividend was 25 cents a share. So, right there, that should have been an early warning sign As soon as the company reduced their dividend. This tells us that something is wrong. The company doesn't believe that they will have enough earnings to cover the dividend, so they have no choice but to reduce the dividend And because they're reducing the dividend, the stock price is going to come down And let's assume they're doing it because the earnings are going to come down. So if the earnings come down again, the stock price is going to come down, and again at that point in 2020,. I haven't looked at it, but if you go back and take a look at the payout ratio, maybe the payout ratio was completely off, or right prior to the dividend announcement. The payout ratio was completely off because the earnings typically will start to come down. So that's another sign of bad news. Is a dividend cut? Okay, so you want to take a look at that, plus the payout ratio as well.

Speaker 1: 26:33

Now stay tuned for our next episode. Where we're going to continue to look at is the dividend safe. How do I know, as an investor, that the dividend is not going to get reduced or eliminated? So we're going to continue that. Next episode we're going to look at we're going to review a history of companies paying dividends. We're going to look for earnings and dividend growth. I'm going to show you what is a dividend trap and how do you avoid it. So if you enjoyed today's episode, be sure to hit the subscribe button, hit the like button as well And, for more information, take a look at our website, simplyinvestingcom. Thanks for watching.