Can the Company Afford Its Dividend? Payout Safety and Coverage Ratios

Book: Corporate Finance: A Practical Approach (2nd ed.)
Authors: Michelle R. Clayman, Martin S. Fridson, George H. Troughton
ISBN: 978-1-118-10537-5

The back half of Chapter 7 shifts from why companies pay dividends to whether they can keep paying them. The 2007-2009 recession produced the biggest wave of dividend cuts since the Great Depression. GE, Toyota, Barclays, UBS, Daimler. S&P 500 dividends fell 25% year over year by mid-2009. If you own dividend stocks, this section is the one to read slowly.

Three policy types in practice

Stable dividend policy is the default. E.ON AG kept raising dividends even when adjusted earnings cratered in 2008. That is the whole point: smooth payouts based on long-term earnings power, not one bad year.

Lintner’s formula for the expected dividend increase:

Expected increase = (Expected EPS increase) × (Target payout ratio) × (Adjustment factor)

Example: dividend was $0.40, target payout 50%, adjustment factor 0.2 (five-year glide path), expected EPS rise $0.50. Expected dividend increase ≈ $0.05. Earnings up 50%, dividend up 13%.

Constant payout ratio makes dividends volatile. Cal-Maine Foods pays one-third of quarterly net income. In a loss quarter, no dividend until cumulative profitability returns.

Residual policy formula: Dividend = Earnings − (Capital budget × Equity % in capital structure), or zero if negative. With €100 million earnings, 70% equity target, and €150 million capex, equity need is €105 million. No dividend. The company borrows rather than issue expensive equity.

Companies sometimes smooth residuals over 5-10 year forecasts, or pair a low stable base dividend with buybacks and specials (Microsoft’s 2004 $3.00 special on top of a small regular dividend).

Dividends vs. buybacks: the choice in practice

Theory says equal amounts are wealth-equivalent. Reality adds wrinkles:

• Tax: buybacks win when capital gains are taxed below dividends.
• Flexibility: buybacks do not set the same “we will keep doing this forever” expectation.
• Signaling: both can signal undervaluation. Buybacks can also signal no good projects left.
• Dilution: buybacks often offset stock option dilution.
• Leverage: buybacks raise debt ratios. Siemens targeted a net debt/EBITDA ratio and bought back €4 billion in two tranches.

Buyback volume rises in strong economies and collapses in recessions. S&P 500 companies spent $1.8 trillion on buybacks from Q4 2004 to Q4 2008 vs. $1 trillion in dividends. The 2008-2009 crash killed repurchases. Banks that had bought back heavily faced survival questions.

Scottsville Instruments’ board debate is a nice capstone. One director feared a cash dividend would signal “no longer a growth company.” Counterpoints: dividend initiations correlate with future earnings growth, the company still has negative investing cash flow (lots of projects), and it had been buying back shares for three years already. A 2% stock dividend would not change wealth. The proposed $0.40 dividend on $3.20 EPS (12.5% payout) that uses all FCFE after projects looks like a residual policy, not a rigid stable one.

Global trends

Fama and French found fewer U.S. industrials paying dividends from 1978-1998, but aggregate payout ratios held near 40-60%. The top 100 companies actually raised real dividends 23%. Two tiers: big stable payers and smaller firms using buybacks instead. That pattern spread across developed markets.

Measuring dividend safety

Traditional ratios:

• Dividend payout ratio = Dividends / Net income
• Dividend coverage ratio = Net income / Dividends

Mature companies often target 40-60% payout (coverage 1.7x to 2.5x). Coverage at 1.0x means the dividend is in jeopardy unless earnings dipped for a one-time reason.

Graham and Dodd (1962): never having cut a dividend may matter more than a long string of increases.

FCFE approach: Free cash flow to equity = CFO − Fixed capital investment + Net borrowing. That is the cash actually available for dividends. Net income can look fine while cash does not.

Comprehensive payout coverage:

FCFE / (Dividends + Share repurchases)

Ratio = 1: returning all available cash. Well above 1: building liquidity. Well below 1: paying out more than you generate, drawing down cash or borrowing. Not sustainable.

Harley-Davidson: earnings lied, cash told the truth

Harley paid dividends since 1993. By the earnings-based coverage ratio:

• 2006: payout 20%, coverage 4.9x
• 2007: payout 28%, coverage 3.6x
• 2008: payout 46%, coverage 2.2x

Still looks okay in 2008. Earnings more than double the dividend.

FCFE coverage of dividends plus buybacks:

• 2006: 0.90x
• 2007: 0.65x
• 2008: 1.50x (but only because of heavy net borrowing)

In 2006 and 2007, Harley returned more cash than it generated. It was running down liquidity and/or adding leverage on purpose. In 2008, almost everything (capex, dividends, buybacks) was debt-funded. The earnings ratio missed the problem. FCFE did not.

Result: on February 12, 2009, Harley cut its quarterly dividend 70% (from $0.33 to $0.10) and halted buybacks.

Warning signs beyond the ratios

• Abnormally high dividend yield vs. history and bond yields. GE yielded nearly 14% before its 68% cut.
• Borrowing to pay dividends and buybacks. Short-term fix, not a policy.
• Past dividend cuts in the record (Graham and Dodd’s point).
• Very high yield vs. history often means the market expects a cut (GE yielded ~14% before its 2008 reduction).

Surprises happen. But high yield plus weak FCFE coverage plus rising debt should put any dividend on your watch list.

My take: I still see investors anchor on payout ratios from the income statement. The Harley example is why that is dangerous. A company can report solid earnings while bleeding cash into buybacks and capex, then bridge the gap with debt until the bridge collapses. If you own dividend stocks for income, FCFE coverage of total payouts (dividends plus buybacks) is the ratio worth building a spreadsheet around. The 2008-2009 cuts were not random. The signs were there for anyone looking past net income.

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