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Too much of a dividend can be a really bad thing

Do you know if your stock's dividend payout ratio is too high?

You know that old expression, "Too much of a good thing is not a good thing."

In the case of stock dividends, as hard as it is to believe, the old saying often speaks the truth, and it's an alarming truth for investors.

I'm not adverse to collecting juicy stock dividends by any stretch of the imagination. As far as I'm concerned, the more the merrier. It's just that the relentless drive to seek passive income from dividends has left many investors with a false sense of security.

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There's only one way to know if an investor should be afraid of what's lurking in their portfolio: earnings per share that are lower than the dividend per share, resulting in what could be a potentially unsustainable dividend payout ratio.

A high dividend payout ratio could result in a surprise cut to the dividend. Worse still, if the dividend was a primary reason to hold the stock, you could have one leg kicked out from under you, resulting in both a capital loss and less income when investors bail on a stock ahead of increasing fears about a dividend cut. This is one of the worst things that can happen to anyone with moderate-to-low risk tolerance and who relies on dividends. This encompasses a great many investors, specifically the baby boomer generation. Boomers are attracted to a high dividend yield like a moth to a flame.

With corporate debt at non-financial companies surpassing the $6.5 trillion mark and with corporate earnings in retreat for the better part of the last year, dividends could be at risk if companies have to start conserving cash in order to survive and/or reinvest their capital.

Corporate bond defaults have risen this year, and there have been dividend cuts, mostly confined to the energy sector. But experience tells us that an economic slowdown or, worse, a recession would bring about a rise in companies that would need to go into cash-conservation mode. And since the U.S. economy isn't exactly going gangbusters right now, there doesn't seem to be a lot of room for error.

"The relentless drive to seek passive income from dividends has left many investors with a false sense of security." -Mitch Goldberg, president of ClientFirst Strategy

Another factor to take into account now is a rising interest rate environment, which could make dividend payouts less valuable for two reasons. They would be less competition with fixed-income securities, and there is potential for inflation, which would cause dividends to lose purchasing power.

This concern cannot be completely eliminated, but investors do need to alleviate it by making sure they have good reason to own any investment regardless of the dividend payout. In my opinion, putting too much emphasis on the dividend is a binary approach to investing. A lot of companies are good at financial engineering, including the dividend, to attract investors and to keep current investors from selling. I receive calls from clients who hear about this and that stock and they say, "Well, it has a nice dividend."

Dividends don't need to be taken out of an investing equation entirely, but a better way to judge a dividend is by looking to metrics beyond the yield. I calculate the dividend payout ratio for my dividend-paying stocks — which is easy to do — and can be quickly done, too.

Simply take the dividend per share and divide it by the earnings per share. This will give you the dividend payout ratio.

If the earnings per share is larger than the dividend per share, then obviously the result will be below 1.0. And with this equation, we want the figure to be lower than 1.0 because it means that the earnings per share are larger than the dividend per share.

Conversely, if the dividend per share is larger than the earnings per share, it would mean that the earnings may not be high enough to sustain the dividend. If that is indeed the case, you'll want to look into why. You may be facing a situation in which a company in that position would have to eventually either cut the dividend or raise its earnings via revenue growth, or reduce expenses by investing less into R&D, a negative for the long run.

The magic number

If you take a look at Chevron, it has a dividend per share of $4.28. Divide that by its reported EPS of $0.69 and you get a ratio of 6.2. This would concern me because the ratio is way over 1.0 and, in my opinion, puts the dividend in the realm of nonsustainability. Of course, energy prices have risen in the second quarter and Chevron may have adjusted its costs enough to raise its earnings, but we'll just have to wait for the next earnings call to find out.

Then you take a look at Apple, which has a rock-bottom dividend payout ratio of 0.25. Yes, Apple's fortunes could take a dramatic turn for the worse, but based on this ratio, it has a heck of a lot of runway before it would need to resort to cutting its dividend.

I like to see a dividend payout ratio under 0.8, because I feel it gives a company enough wiggle room to maintain the dividend if its earnings fall a little. A ratio below 0.5, I feel, would actually give a company enough room to possibly raise its dividend sometime down the road.

By Mitch Goldberg, president of ClientFirst Strategy

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