Dividend Safety Scores

What are Dividend Safety Scores?

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
  • Recession performance
  • Dividend longevity
  • Industry cyclicality
  • Free cash flow generation
  • Business volatility
  • 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 and rank the safety of a stock’s payout 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 appears to have an extremely reliable dividend.

 

Alternatively, a score of 1 indicates that the company scored lower than 99% of all other dividend stocks for payout safety and appears to have greater risk of cutting 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 60 or higher for safety, a lot of pain can potentially be avoided for conservative 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.

 



In late April 2016, we began tracking dividend cut announcements for all companies that had Dividend Safety Scores in our database.

 

Since then, companies reducing their dividends had an average Dividend Safety Score below 20 at the time of their announcements.

 

Companies that cut their dividends by at least 50% had an average Dividend Safety Score below 15.

 

The table below shows each company’s Dividend Safety Score at the time the dividend cut was announced, the magnitude of the cut, and a link to the original announcement from the company:

 



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.

 

Dividend Safety Scores

 

Two observations jump out at me. First, 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.

 

The second observation from the chart is that all but two companies that cut their dividends scored close to 40 or below for Dividend Safety, falling in the “Unsafe” and “Extremely Unsafe” buckets.

 

One exception was Ecology and Environment (EEI), a micro-cap stock that scored an 82 for Safety and lowered its dividend by 17%.

 

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.

 

PG&E (PCG) was a rather tricky case as well. The regulated utility company had a Dividend Safety Score of 91 before it announced it was temporarily suspending its dividend.

 

Wildfires were causing extensive damage throughout California, and PG&E was under investigation to see if it caused some of the fires. If so, the company would face a large liability.

 

PG&E decided to preserve cash by temporarily suspending its dividend until more is known about the ongoing situation.

 

Here’s what PG&E’s Chair of the Board Richard Kelly stated:

 

“After extensive consideration and in light of the uncertainty associated with the causes and potential liabilities associated with these wildfires as well as state policy uncertainties, the PG&E boards determined that suspending the common and preferred stock dividends is prudent with respect to cash conservation and is in the best long-term interests of the companies, our customers and our shareholders…We fully recognize the importance of dividends and intend to revisit the issue as we get more clarity.”

 

I’m not sure much could have been done to get in front of this one. This was a rather binary outcome that seemed to have a low probability at the time and couldn’t be traced in PG&E’s financial statements, which were otherwise in decent shape.

 

Fortunately, the vast majority of dividend cuts that occur show plenty of clues in a company’s financials in advance.

 

How to Use Dividend Safety Scores

Dividend Safety Scores can be used to screen for dividend stocks, research an individual stock, and analyze a dividend portfolio for safety.

 

Investors can access Dividend Safety Scores and a number of other research tools to improve their portfolios with a 10-day free trial (no credit card required).
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