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The term "safe" is a relative one. Most people feel safer in their car than on an airplane even though statistics clearly prove the plane is a safer way to travel. Some people don't feel safe sleeping in an isolated cabin in the woods but have no problems walking down a city street at night. A person's feeling of safety is defined by their past experiences and observations which determines their own personal comfort within a situation. The same goes for a person's definition of safe when deciding on making an investment.

My Grandmother was a child of the Great Depression. She has led a sheltered life and is very careful with her money. I have had no luck trying to convince her that CDs are not a very good investment for generating income. She doesn't care, she knows they are "safe" as they are FDIC insured. She does not understand that her one year CD earning 1% is actually losing money when you include the effect that the current rate of inflation has on her investment.

Dividend Safety Analysis

In today's low interest environment prudent investors have turned to dividend stocks to provide them with the income they need. But if someone is investing for the purpose of dividend income, how can they assess the "safety" of that current dividend payment I have been working on a way to analyze a company's current dividend and assign a value to the safety of that dividend payment based on financial metrics. This is by no means an end-all be-all way of fully determining a company's ability to pay its dividend, but it should help shed light on its strengths and identify any potential weaknesses that should be looked into further. Below are the metrics I will look at and the point values assigned to each.

Number of consecutive years a dividend has been paid

  • 1 point for more than 9 years
  • 2 points for more than 29 years

Number of consecutive years a dividend has been increased

  • 1 point for more than 9 years
  • 2 points for more than 29 years

Annual dividend cuts in the past 10 years

  • -2 points for each cut

Free cash flow (FCF) payout ratio

  • 1 point for most recent FY less than 75%
  • 1 point for five year average less than 75%

Negative free cash flows in the past 10 years

  • -1 point for each year there was a negative free cash flow

Amount of cash on hand to cover annual dividend payment

  • 1 point for every year a company's dividend is covered by current cash on hand
  • -1 point if there is less cash on hand than one year's dividend payment

Most recent FY profit margin vs. five year average (this helps us see if competition or other variables are eroding the company's profitability)

  • 1 point if most recent FY is more than or within 5% of the five-year average profit margin
  • -1 point if most recent FY profit margin has decreased more the 5% vs the five-year average

Debt to total capital (ratio used to determine how levered a company is)

  • 1 pt if less than or equal to 60%
  • -1 pt if more than 60%

Current ratio (ratio used to determine how much liquidity a company has)

  • 1 pt if greater than or equal to 1.0
  • -1 pt if less than 1.0

Quick ratio (ratio used to determine if a company has sufficient liquid assets to meet short-term operating needs)

  • 1 pt if greater than or equal to 1.0
  • -1 pt if less than 1.0

Interest coverage ratio (ratio used to determine how easily a company can pay interest on outstanding debt)

  • 1 pt if greater than or equal to 1.5
  • -1 pt if less than or equal to 1.5

S&P Bond rating of the stock

  • 1 pt for BBB- and up (Investment Grade)
  • -1 pt for BB+ and lower

In order to see how certain companies would grade in this analysis I took a look at three different dividend stocks. Financial metrics below come from morningstar.com.

Microsoft (NASDAQ:MSFT), one of the world's largest software companies, develops PC software, including the Windows operating system and the Office application suite. Current yield is 3.3%.

Clorox (NYSE:CLX) is a diversified producer of household cleaning, grocery and specialty food products as well as a leading producer of natural personal care products. Current yield is 3.5%.

CenturyLink (NYSE:CTL) operates as an integrated telecommunications company in the United States. Current yield is 6.9%.

Based on the above analysis of each stock we learn a number of things. First, although CenturyLink has double the yield of Microsoft and Clorox, its financial metrics present a number of red flags. The negatives counteract the positives of the stock giving it a safety score of zero and leads us to believe that the current dividend should not be considered safe. Microsoft appears to be an incredibly safe dividend stock based on all metrics with a score of 20. Some may argue that Microsoft carries too much cash on hand and should be using it for internal growth or acquisitions, but an income investor should see that cash hoard as a sign that the current dividend is an absolute certainty. Finally, Clorox scored a strong score of 7, but there were a few red flags that should lead an investor to do further due diligence before deciding to invest for dividend income purposes.

Conclusion

Income investors avoiding dividend stocks because they believe they are not safe are missing out on significant returns for their perceived safety net. Investing in Microsoft today will generate 230% more income in a year than investing in a 1 Year CD. Is the CD's FDIC insurance worth a 230% decrease in income return? With Microsoft's stellar balance sheet and cash on hand wouldn't you classify its dividend as safe?

I'd like for SA readers to weigh in. What metrics do you look at when trying to determine the safety of a dividend stock? Do you feel any of the metrics above carry too much weight or not enough? What companies do you believe have the safest dividends in the market today and why?

Also, I realize the above metrics would not work for all types of stocks. I intend to build a REIT specific analysis in the near future to address those stocks.

Source: Analyzing The Safety Of A Dividend

Additional disclosure: The 4% Retirement Portfolio service recommends MSFT.