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Dividend investing gained a lot of popularity recently. Many bloggers and YouTubers tout dividend stocks and their steady income stream. But, there is very little education given on dividend safety and the kind of red flags to watch out for.

This post will cover how to determine if a dividend stock is safe and its dividend policy is sustainable.

3 Pillars of Dividend Investing Analysis

The research for dividend stocks is very similar as for any other stock. There are three pillars to look into. They are:

1. Economic Moat
2. Financial Analysis
3. Valuation

1. Economic Moat

Before even looking at financial ratios, the key thing for a dividend safety is economic moat. What do I mean by economic moat? Economic moat is a durable competitive advantage that allows a company to earn excess returns long-term.

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In essence, you want a company that does certain things better than others. Moreover, these better business practices must be hard to replicate for competitors. Thus, this unique combination of factors allows a firm to earn returns above its cost of capital well into the future.

For instance, it could be GPU technology that enabled Nvidia’s meteoric rise to stardom.  Or it could be a brand that Nike built around its sneakers. Or cost efficiencies that your local utility firm developed. Either way, economic moat should be a priority to know for a dividend stock.

Assessment of a company’s economic moat is a qualitative study for the most part. But, one way to test for economic moat is to look at the return on invested capital (ROIC).

\text{ROIC} = \dfrac{\text{NOPLAT}}{\text{Invested Capital}}

where NOPLAT is the net operating profits, losses after taxes.

For instance, Intel has enjoyed an outstanding return on invested capital up until 2019. But, many factors eroded its economic moat and the company lost its competitive edge.

Table 1. Intel’s Margins and ROIC

Many of its competitors, such as TSMC, zipped past its chip technology. Recently, AMD started taking Intel’s market share in the cloud servers market. Consequently, Intel’s ROIC declined due to falling profitability and low growth rates. Eventually, Intel had to cut its dividend from $1.46 to $0.50 per share in 2022. 

Strong economic moat can also minimizes the risk of capital depreciation for a stock. In the end, it does not matter what the dividend yield is. If a stock price declines by 20%, who cares about a 3% yield, right? Many companies lure investors with high yields only to experience financial problems, dividend cuts and stock price declines.

2. Financial Analysis

The next task is to look closely at a company’s finances. Here, you want to study the following metrics:

• quality of revenue/earnings growth
• debt ratios
• free cash flow metrics
• dividend growth and history
• payout ratios

Let’s look at a specific company to illustrate the point with a benefit of a hindsight. Take VF Corporation (VFC), which announced a 41% dividend cut in 2023. As of October 2023, its forward dividend yield stands at about 6.4%. VFC is in the apparel business. Its brands collection include Vans, The North Face and Timberland.

Growth, Margins and Returns

Looking at VFC’s income statement, we see that top line growth was non-existent in the past 10 years.

Table 2. VF Corporation Growth, Margins and ROIC

There is a notable exception in 2021 with a 28% jump in revenue growth. The operating earnings growth had a similar or even worse picture.

Overall, it is important to look into the quality of revenue and earnings growth. If a company’s growth comes from expensive acquisitions or one-time events, it is no good.

Looking at VFC’s 10-K, we learn that about 6% of the 28% growth came from acquisition and favorable forex fluctuation.

Thus, this leaves us 22%. On a surface, this looks impressive. But, that number is mostly based on consumers’ shopping spree after Covid-19. It is very unlikely that this double-digit growth rate is sustainable. 

As for ROIC, VFC showed more or less consistent results, but there was a declining trend after 2019. Similarly, operating margins started declining after 2019. Even post-pandemic bump did not help the company. Thus, it looks like 2022 was just a temporary reprieve. 

Based on my research, there are several factors behind this. But, the main one is a changing retail landscape in the U.S. Many clothing stores are going bankrupt or closing. This development puts VFC’s distribution channels, ordering and pricing in total disarray. As you see, it is important to dig deeper and understand how long these negative trends will last. 

Debt Ratios, Cash Flows, Payouts and Dividend

Next is the leverage. Back in 2018, VFC had about $2.8 billion in debt. Fast forward today and we have $8.2 billion on the books.

Table 3. VF Corporation Debt Ratios, Dividend and Cash Flows

Increasing debt doubled VFC’s financial leverage. At the same time, its debt-to-equity ratio increased almost fivefold. VFC took on more debt to cover acquisition, declining operating cash flows and dividend payments. 

Next is the payout ratio. In my experience, the payout ratio is a somewhat flawed metric to look at. This is so because there is tons of noise from non-operating and non-cash profits and losses. A better metric would be the dividend divided by the free cash flow (FCF). The free cash flow is the operating cash flows net of capital expenditures.

From Table 3 we see that the dividend to FCF ratio was becoming less and less sustainable. For an astute investor, this dividend cut was a matter of time. VFC had to take this measure to preserve cash for future debt repayments and other operating needs.

3. Valuation

Another aspect of dividend analysis is to look into a company’s valuation. Because valuation is a very involved process, a full-scale valuation analysis is beyond the scope of this tutorial. 

But, think of looking at a company’s valuation as a long-term hedge against stock price declines in the future. If you buy a stock at a price below its intrinsic value, you get a certain margin of safety. This margin of safety will safeguard you against price declines in case you turn out wrong.

If you want to learn more about investment valuation, subscribe to my blog newsletter. Also, you can educate yourself by reading various books on valuation. One authoritative book that stands tall above anything I have seen is Valuation by McKinsey and Company. Whenever I need to look something up, this book usually has comprehensive answers.

Let’s take a look at VFC relative valuation and try to tease out if the dividend was safe before it was cut in 2023. Let’s observe price-to-sales (P/S), price-to-book (P/B) and enterprise value to earnings before interest and taxes (EV/EBIT).

Table 4. VF Corporation Valuation

We see that all three ratios were somewhat elevated around 2020 and 2021 on a historic basis. But, after that, things turned south. In 2022, VFC stock experienced a rapid capital depreciation. This was the result of declining margins, returns and decelerating top line growth. 2022 was the year to pay attention to and get out (or not to get in).

But, only looking at relative valuation on a historic basis misses on many other important value aspects. These include the following:

1. future expectation of growth
2. risk
3. reinvestment needs
4. returns

If you are not analyzing and controlling for these metrics in your valuation, it is a pointless exercise. Also, it is necessary to compare a company’s valuation to its peers. So, as you can see, there is a lot of digging to be done before we can conclude if a dividend stock is worth it.

From Table 4 we see that the relative valuation metrics are at all-time low. But, so are returns and margins. On top of that, VFC became much more levered. Depending on what the future holds for VFC, it could be a fantastic value play with a great dividend yield. Conversely, it could be a terrible value trap with even more stock declines.

The right questions to ask are these. What does VFC expect to earn on a per share basis going forward? Is competitive dynamics changing in favor or against the company? Will VFC face financial hardship due to mounting debt burden? Are there any brand impairments? Does VFC have to invest even more in the future to stay competitive? Will any of its acquisitions go off the rails and more goodwill write-offs are looming?

Only then we should estimate its intrinsic value and determine if it is worth investing in VFC. In my future posts, I will do a more in-depth analysis of companies’ relative and DCF valuations.

Concluding Takeaways

If you have no time for researching dividend stocks, investing in dividend-focused ETFs is a much better option. Of course, you will not get the same dividend yield as with VFC, but at least your fortunes will not be tied to one company.