Companies that have graduated from the growth stage may choose to pay dividends to their shareholders. A dividend is a cash distribution of a company's earnings to its shareholders, which is declared by the company's board of directors. A company may also issue dividends in the form of stock or other assets. Generally, dividend rates are quoted in terms of dollars per share, or they may be quoted in terms of a percentage of the stock's current market price per share, which is known as the dividend yield.
Some stocks have higher yields, which may be very attractive to income investors. Under normal market conditions, a stock that offers a dividend yield greater than that of the U.S. 10-year Treasury yield is considered a high-yielding stock. As of May 18, 2016, the U.S. 10-year Treasury yield was 1.87%. Therefore, any company that had a trailing 12-month dividend yield or forward dividend yield greater than 1.87% was considered a high-yielding stock. However, prior to investing in stocks that offer high dividend yields, investors should analyze whether the dividends are sustainable for long periods. Investors who are focused on dividend-paying stocks should evaluate the quality of the dividends by analyzing the dividend payout ratio, dividend coverage ratio, free cash flow to equity (FCFE) and net debt to earnings before interest taxes depreciation and amortization (EBITDA) ratio.
Dividend Payout Ratio
The dividend payout ratio may be calculated as annual dividends per share (DPS) divided by earnings per share (EPS) or total dividends divided by net income. The dividend payout ratio indicates the portion of a company's annual earnings per share that the organization is paying in the form of cash dividends per share. This may also be interpreted as the percentage of net income that is being paid out in the form of cash dividends. Generally, a company that pays out less than 50% of its earnings in the form of dividends is considered stable, and the company has the potential to raise its earnings over the long term. However, a company that pays out greater than 50% may not raise its dividends as much as a company with a lower dividend payout ratio. Additionally, companies with high dividend payout ratios may have trouble maintaining their dividends over the long term. When evaluating a company's dividend payout ratio, investors should only compare a company's dividend payout ratio with its industry average or similar companies.
Dividend Coverage Ratio
The dividend coverage ratio is calculated by dividing a company's annual EPS by its annual DPS, or dividing its net income less required dividend payments to preferred shareholders by its dividends applicable to common stockholders. The dividend payout ratio indicates the number of times a company could pay dividends to its common shareholders using its net income over a specified fiscal period. Generally, a higher dividend coverage ratio is more favorable. While the dividend coverage ratio and the dividend payout ratio are good measures to evaluate dividend stocks, investors should also evaluate the (FCFE).
Free Cash Flow to Equity
The FCFE ratio measures the amount of cash that could be paid out to shareholders after all expenses and debts have been paid. The FCFE is calculated by subtracting net capital expenditures, debt repayment and change in net working capital from net income and adding net debt. Investors typically want to see that a company's dividend payments are paid in full by FCFE.
Net Debt to EBITDA Ratio
The net debt to EBITDA ratio is calculated by dividing a company's total liability less cash and cash equivalents by its EBITDA. The net debt to EBITDA ratio measures a company's leverage and its ability to meet its debt. Generally, a company with a lower ratio, when measured against its industry average or similar companies, is more attractive. If a dividend-paying company has a high net debt to EBITDA ratio that has been increasing over multiple periods, the ratio indicates that the company may cut its dividend in the future.
Investors who seek to evaluate dividend stocks should not stick to just one ratio, because there could be other factors that indicate the company may cut its dividend. Investors should use a combination of ratios, such as those outlined above, to better evaluate dividend stocks.