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3 Signs of a Safe Dividend

The interplay of several elements--economic moats, strong finances, and balanced payout ratios--creates a reliable stream of dividends, says Morningstar's Josh Peters.

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Note: This article is part of Morningstar's November 2015 Income Investing Week special report.

Dependable. Stable. Reliable. These words often come to mind when investors think of dividend-paying stocks--unless these investors own Wynn Resorts (WYNN) or Freeport-McMoRan (FCX), both of which cut their dividends earlier this year.

How can you make sure the stock you own today will continue to pay its dividend tomorrow? Josh Peters, editor of Morningstar DividendInvestor and author of The Ultimate Dividend Playbook: Income, Insight, and Independence for Today's Investor, argues that a trio of factors collaborates to generate a steady stream of dividends.

Here are the signs to look for when evaluating a company's ability to maintain its dividend.

1) An Economic Moat
An economic moat, which encapsulates a company's competitive advantage, is one of the best tools to identify the stability of a company's profit stream. As such, it's one of the most important metrics for dividend-stock investors to evaluate. "If you're hanging around for the dividend over the long run, then you have to think about the company's long-run earnings power, and that is almost entirely going to be shaped by the company's competitive position in its industry," says Peters.

"No-moat companies are substantially more likely to cut their dividends during recessions than narrow- and wide-moat firms," says Peters. That's because these companies' profits--and, therefore, their dividends--are more vulnerable than those of wide-moat firms. "An economic moat does not guarantee dividend safety, of course," adds Peters. General Electric (GE) held a wide moat rating when it reduced its dividend in 2009, he says. Nevertheless, moats offer some protection of future dividend payments. As such, Peters requires that a company earns a Morningstar Economic Moat Rating of narrow or wide before investing.

For more about moats and dividend-paying stocks, watch "Why Moats Matter for Equity Income."

2) Strong Finances
Common-stock shareholders collecting dividends sit on the bottom rung of a company's ladder of financial obligations. They're only paid after other obligations--such as those from banks, bondholders, suppliers, employees, pensions, and so on--are met. "Being the last in the pay line, we want to see that this line is not too long," says Peters. Peters warns that with highly leveraged companies, it's especially important to be aware of financial covenants with bankers or bondholders that can trigger defaults even before the company runs out of resources. "If this seems beyond your grasp, simply avoid highly leveraged situations," he advises.

Peters also recommends that dividend investors understand all claims on a company's cash, which may include pension deficits, tax problems, or legal threats. "Liquidity can be an important factor, too," he adds. "Dividends may come indirectly from earnings, but they're paid in cash." As such, dividend seekers should favor companies with cash reserves or large lines of credit that can smooth out bumpy cash flows and, therefore, allow for a steady dividend payout.

Peters uses Morningstar's corporate credit ratings as a reference point when evaluating the financial strength of a company. The ratings are accessible via the "Bonds" link from any report page. "The credit ratings do not translate directly to the safety of dividends," acknowledges Peters. A company could be financially solid from a credit standpoint yet still cut its dividend. Nevertheless, Peters notes he generally buys stocks in companies with credit ratings of investment-grade (BBB+ or higher).

3) Balanced Payout Ratios
The payout ratio is the proportion of a company's earnings being paid out as dividends. For instance, if a company is earning $2 per share annually and paying a $1.20 dividend, the payout ratio is 60% ($1.20 divided by $2.00). The inverse of the payout ratio--here, 40%--tells you how far earnings could drop before the dividend would no longer be covered by earnings. You can find the payout ratio of a given company by clicking the "Key Ratios" tab on a company report.

"The payout ratio may be the single most important statistic in evaluating a dividend's safety," says Peters, "but there's always a bit of tension." Lower payout ratios are generally safer than higher payout ratios, because earnings can fall further without threatening the dividend. That said, higher payout ratios can generate higher dividend yields. As such, investors focusing exclusively on lower payout ratios may wind up with lower dividend yields. "What we're looking for is balance--current yield versus safety, as well as current yield versus future growth," says Peters.

Put another way, according to Peters, the payout ratio cannot be separated from its context. Some businesses can maintain high payout ratios and safe dividends.        Altria (MO), for instance, currently carries a 80% payout ratio for the trailing 12 months. "It's a very steady business," he says. "Management doesn't need to plow any money back into the business to grow; it grows earnings by raising the price of cigarettes faster than people are quitting." As such, an 80% payout ratio makes sense for this particular company. A high payout ratio is fine if the business can support it.

For more about the payout ratio, watch "Dividend Payout Ratio Is Important, Too."

And Then, Management
"All of the foregoing should be considered in the context of management," reminds Peters. If management isn't dedicated to maintaining the dividend, it won't matter how wide the company's moat is, how strong its finances are, and how balanced its payout ratio is. Peters recommends considering past actions, as well as anything management has recently said. "Even a dividend cut that happened 10 or 20 years ago might tell you something interesting about the business," he says. "And a more-recent dividend cut should tell you quite a lot."

Are you looking for tips on improving your portfolio? As part of Morningstar.com's Portfolio Makeover Week in December, director of personal finance Christine Benz will be making over five real-life portfolios to show how investors of all stripes may streamline and upgrade their holdings. To be considered for a makeover, submit a request to portfoliomakeover@morningstar.com. Include a general description of your situation, including portfolio size, as well as your goals for the makeover. We will alert you if we decide to feature your portfolio on the site and will remove any personally identifying information in any published material.

Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.