Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How to Spot a Dividend Cut Before It Happens
Transcript
- Lucas: So United Wholesale Mortgage suspended its dividend this week and raised capital, and the stock plunged thirty-five percent in a single day. That is a brutal reminder that a juicy yield is only as good as the company's ability to keep paying it. Luna: Yeah, I saw that headline. It's one of those moves that feels like it comes out of nowhere, but usually the signs were there long before the announcement. Lucas: Exactly. And that's what I want to dig into today: how do you spot a dividend cut before it actually happens? Because if you're holding a stock for income, a cut can wipe out years of accumulated dividends in one day. Luna: So what are the telltale signs? Is it just about the payout ratio? Lucas: The payout ratio is a good starting point, but it's not enough on its own. For United Wholesale Mortgage, the payout ratio was actually over one hundred percent in the last few quarters, meaning they were paying out more in dividends than they were earning. That's a huge red flag. Luna: Right, but some companies with high payout ratios are fine because they have strong cash flows. How do you tell the difference? Lucas: Great question. That's where free cash flow coverage comes in. You want to compare the dividend to free cash flow, not just earnings. A company can have positive earnings but still be burning cash if it's investing heavily or if its working capital is eating up funds. Luna: And when free cash flow starts to decline, that's when the dividend becomes vulnerable. Lucas: Precisely. If you see free cash flow coverage below one, meaning the dividend exceeds free cash flow, that's a warning sign. United Wholesale Mortgage had that problem. They were funding the dividend with debt and capital raises, which is not sustainable. Luna: So what's a healthy level? Like, what should investors look for? Lucas: For most companies, you'd want free cash flow coverage of at least one point two to one point five times. That gives you a cushion if business slows down. If it's below one, the company is essentially borrowing to pay shareholders, and that can only last so long. Luna: And what about the balance sheet? Debt levels matter a lot too, right? Lucas: Absolutely. Look at the debt to equity ratio and the interest coverage ratio. If a company is highly leveraged and rates are rising, more of its cash flow goes to interest payments, leaving less for dividends. That's especially relevant right now with the ten-year Treasury up to four point six nine percent. Luna: So higher rates are putting pressure on companies with a lot of debt, which is something dividend investors need to watch. Lucas: Yeah, and that's why I think Verizon is a good counterexample. A lot of people worry about Verizon's dividend because the yield is high, around six and a half percent. But if you look under the hood, the free cash flow coverage is actually pretty solid, and they've been paying a dividend for decades. Luna: So even though the yield is high, the fundamentals are healthier than people think. Lucas: Exactly. And that's the key: don't just chase yield. A high yield can be a sign that the market expects a cut. That's the 'yield trap' idea. But if the company's earnings and cash flow support the dividend, then the high yield might just be a buying opportunity. Luna: So when you're screening for dividend stocks, what's your checklist? Payout ratio, free cash flow coverage, and debt levels? Lucas: Yeah, those are the big three. And then you want to look at the dividend history. A company that has increased its dividend for twenty or thirty years is less likely to cut it, because they have a track record of managing through downturns. But even those aren't immune, as we saw during the financial crisis. Luna: Right, some banks cut their dividends for the first time in decades back then. Lucas: So nothing is foolproof. But by combining those three metrics, you can filter out the most obvious risks. And that's what I did when I looked at United Wholesale Mortgage a few months ago. The payout ratio was over a hundred percent, free cash flow was negative, and they had a ton of debt. It was only a matter of time. Luna: That's a great example of why doing your homework matters. And honestly, if today's conversation helps you think about your own portfolio with a bit more scrutiny, that's exactly why we do this. Lucas: And if it was worth a coffee to you, we'd appreciate that. You can support the show at buy me a coffee dot com slash fexingo. It keeps the podcast ad-free and helps us keep digging into these topics. Luna: Yeah, every little bit helps, and we're grateful to everyone who already does. Lucas: So back to the checklist. Once you've got your three metrics, you also want to check the payout ratio trend over a few years, not just the current quarter. A gradual increase from fifty percent to eighty percent is a warning sign, even if it's not a crisis yet. Luna: That makes sense. And what about special dividends or one-time payouts? Those can distort the numbers, right? Lucas: Good point. When you're calculating payout ratios, you want to use the regular dividend, not special dividends. Those are one-offs and shouldn't be counted as a recurring commitment. Luna: So if you see a company that pays a special dividend, it might not be as generous as it looks. Lucas: Exactly. And one more thing: keep an eye on management's tone. If they start talking about 'returning capital' in vague terms or if they pause share buybacks, that could be a hint that they're conserving cash for a reason. Luna: Yeah, actions speak louder than words, but sometimes the words give it away. Lucas: Right. So let's wrap this up with a practical takeaway. If you're looking at a stock with a yield above five percent, do the math before you buy. Check the payout ratio, free cash flow coverage, and debt to equity. If any of those look stretched, ask yourself if you're getting paid enough to take that risk. Luna: And remember, a dividend cut isn't the end of the world if you're diversified, but it can be a painful hit to your income stream. Lucas: Yeah, and that's why it's better to avoid the landmines altogether. Hopefully this gives you a way to spot them before you step on one.