Our Dividend Safety Score measures a company’s ability to continue paying its current dividend and helps investors find the safest sources of income for their portfolios.
Dividend Safety Scores analyze the most important metrics from a company’s financial statements and answer the question, “Is the current dividend payment safe?”
In many ways, Dividend Safety Scores can be thought of as being similar to “bond ratings” by credit agencies except they are applied to dividends rather than debt.
Brian Bollinger created Dividend Safety Scores. Brian is a registered Certified Public Accountant and worked as an equity research analyst at a multibillion-dollar investment firm prior to starting Simply Safe Dividends (more on his background here).
How are Dividend Safety Scores Calculated?
Our goal is to never own a business that reduces its dividend. Companies usually give off a number of warning signs before they actually cut their dividends.
The companies most likely to cut their dividends usually have some combination of high payout ratios, weak free cash flow generation, declining sales and earnings, weak balance sheets, cyclical operations, and no proven commitment to paying and growing dividends over time.
Dividend Safety Scores take into account more than a dozen fundamental factors that influence a company’s ability to continue paying dividends.
They are meant to be a much more comprehensive measurement of risk than simply looking at a company’s dividend growth streak (e.g. 23 years) and payout ratio.
Here are some of the main factors we use to assess a dividend’s safety:
Earnings and free cash flow payout ratios
Debt levels and coverage ratios
Free cash flow generation
Near-term sales and earnings growth
Return on invested capital
Here is a rough estimate of how much each group of factors impacts our Dividend Safety Scores:
1) Income Statement / Coverage metrics: 35-45%
2) Balance Sheet / Credit metrics: 25-35%
3) Dividend History / Longevity: 10-20%
No quantitative system is ever going to be 100% accurate, but Dividend Safety Scores help income investors identify and avoid companies that might be riskier than they desire – without needing to get into the weeds of balance sheets and income statements (although we always encourage it).
Interpreting Dividend Safety Scores
Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak.
A stock’s Dividend Safety Score represents its safety rank relative to all of the other dividend-paying stocks in the market.
For example, a Dividend Safety Score of 100 means the stock scored in the top 1% of all dividend stocks for safety and has an extremely reliable dividend.
Alternatively, a score of 1 indicates that the company scored lower than 99% of all other dividend stocks for safety and is one of the most likely companies to cut its dividend in the future.
The table below indicates how investors should interpret Dividend Safety Scores:
During the financial crisis (2008-09), roughly one-third of dividend-paying companies in the S&P 500 cut their dividends. Ideally all of those companies would have scored in the bottom 30-40% for Dividend Safety prior to their cuts.
By sticking with firms that score at least 50-60+ for safety, a lot of pain can potentially be avoided for income investors.
Dividend Safety Scores: Track Record
Since their launch in mid-2015, Dividend Safety Scores have flagged a number of major companies as high risk stocks before they cut their dividends.
As seen below, Kinder Morgan, ConocoPhillips, BHP Billiton, National Oilwell Varco, Noble Energy, Devon Energy, CONSOL Energy, and Anadarko Petroleum all scored in the bottom 10-20% for Dividend Safety and had an average score of 5 at the time of their dividend cut announcements.
The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. These are the Dividend Safety Scores that were available before a company’s dividend cut was announced, providing predictive value.
Two observations jump out at me. First, all but two of the companies cutting their dividends scored close to 40 or below for Dividend Safety, falling in the “Unsafe” and “Extremely Unsafe” buckets.
The two exceptions were Ecology and Environment (EEI), a micro-cap stock that scored an 82 for Safety and lowered its dividend by 17%, and Superior Industries (SUP), a small-cap stock that reduced its dividend by 50% and scored a 46 for Dividend Safety.
In the case of Ecology and Environment the company’s fundamentals were actually very healthy, but management decided it wanted to invest more for growth, freeing up additional cash for reinvestment by reducing the dividend by 17% (read the company’s press release here).
I am not really sure there was much we could have done to flag this dividend cut ahead of time since management’s decision to reduce the dividend had little to do with the company’s actual fundamentals (e.g. payout ratios, earnings growth, balance sheet, dividend longevity etc.). However, we do treat micro-caps with greater conservatism today in recognition of their generally more dynamic capital allocation policies.
Superior Industries was coming off an excellent year of double-digit revenue and profit growth, maintained a clean balance sheet with no debt, and had a solid history of paying dividends for more than 20 years.
So what happened? Management decided to make a transformational acquisition, taking on substantial debt to more than double the size of the business. As a result of the company’s new capital structure, Superior Industries decided to adjust its dividend.
I am not sure there is anything we could have done to get in front of this unique event either because it had nothing to do with the company’s current fundamentals and business outlook.
The second observation from the chart above is that companies with lower Dividend Safety Scores were more likely to cut their dividends by larger amounts. You can see that most of the biggest dividend cuts (e.g. 50%+) happened with companies scoring below 10 for Dividend Safety.