It has been a while since I was so inspired by a personal finance blog post, but the FIRE blogger, Mr. Tako recently wrote something titled, “The Lifecycle of an Investment” that felt like a punch to the gut. In it, he briefly discusses the different cycles of a company and when to get in and out. It wasn’t his intended consequence but I immediately thought of my dividend growth investment portfolio and what my sell metrics should/may be.
The Purpose of my Dividend Growth Investment Portfolio
I have a very specific goal in mind as I build my dividend growth investment portfolio.
My dividend growth investment account is meant to be a stream of income later in my life. One day I want to be able to stop the dividend reinvestments and then have a quarterly check to supplement my lifestyle.
It is with that eventual goal in mind that a dividend cut would be catastrophic. First of all a dividend cut to a consistent dividend paying stock destroys the stock price, so then I am stuck selling a stock at what would be considered a low. Second, I am now holding a stock where my goals and objectives may not be in line with the current management.
As such, it may be worth taking a moment to see if any of my holdings are in danger of a dividend cut.
My Sell Metrics
So if my goal is to avoid a dividend cut let’s look at some factors which may cause or predict an eventual dividend cut. First, and foremost, I think payout ratio has to be looked at. The Payout Ratio is
the total amount of dividends paid out to shareholders relative to the net income of the company. It is the percentage of earnings paid to shareholders in dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or to reinvest in core operations.
For purposes of a red flag I am going to be looking for a payout ratio of more than 60%. However to be more specific, I am going to see if I can find a trend of a growing payout ratio which would indicate either raising expenses or slowing of top line growth – either way it is likely a problem.
The second metric to take a look at is the Free Cash Flow which is,
Free cash flow is the amount of cash generated by the company which is available to pay dividends, buy back shares, pay down debts or acquire other companies. It’s calculated as:
Free cash flow = Net cash from operations (net of interest and tax) – capital expenses
The companies I continue to hold should have enough free cash flow to pay their dividend “obligations” going forward. If there is a payout ratio problem then I think it would be prudent to review the FCF yield in terms of historical averages.
The third, and last metric, I am going to be using is the interest coverage ratio. The interest coverage ratio is,
Times interest earned, or the interest coverage ratio, is the traditional measure of a company’s ability to meet its interest payments; it is calculated by dividing earnings before interest and taxes (or earnings before interest, taxes, depreciation and amortization) by the total interest payable.
Times interest earned indicates how well a company is able to generate earnings to pay interest on its debt, which must be paid before dividends can be paid out. The larger and more stable the ratio, the lower the risk of the company defaulting.
In addition, the higher this ratio, the more flexibility a company has in being able to meet its financial obligations and have money left over for dividends, expansion, etc. As this ratio falls, the risk of a company defaulting on its debt obligations increases.
A ratio of less than one indicates that the company’s current earnings are not high enough to meet their current debt obligations, meaning that it will need to liquidate assets to make up for the shortfall, find additional funding—or even reduce or eliminate the dividend.
Interest payments can kill a company’s dividend, as such, I am going to make sure all of my holdings do not have a ratio of less than one.
Reviewing my Dividend Growth Investment Portfolio Holdings
Taking a look at all my holdings against the above metrics:
|Payout Ratio||Free Cash Flow||Interest Coverage Ratio|
Those cells with ? in it I couldn’t find the information despite checking multiple sites! Frustrating, but at this point I am going to let it go. I am particularly worried about:
- ADM due to it’s negative free cash flow; and
- PPL due ot it’s high payout ratio and negative FCF
I am going to continue to watch these two holdings, and likely sell before or after the new year depending if I have built in gains/losses.