One of the things that is most alluring about dividends is that they are real hard cash. They simply can’t be faked and they can’t be taken back. That said, dividend payments can be cut or eliminated if a financially weak company gets into trouble. This can happen for any number of reasons, but for an investor using dividend payments to augment their income, the end result is a pay cut.
There are many ways to examine a company and attempt to determine its ability to continue paying dividends. One quick and easy method is to check a company’s payout ratio. The payout ratio takes dividends and divides such payments by net income, essentially showing the percentage of earnings that is going to cover dividend payments. The lower the percentage the better, as it indicates that there are ample earnings to keep paying a dividend, even if there are short-term financial strains that may temporarily depress a company’s earnings. Although dividends are paid from cash flow, looking at how well dividends are covered by earnings, rather than cash flow, creates a stricter criterion that helps to identify some of the safest and best covered dividends.
To help identify stocks that income investors might find interesting for both their dividend yield and their dividend coverage, we used Value Line’s online screening tool to find companies with payout ratios below 30% and dividend yields above 2.5%. Two of the companies from the list of 61 that stood out for their investment merit were ACE Limited (ACE) and Safeway, Inc. (SWY).
Subscribers can recreate this screen making it more or less stringent as they wish. Note that some industries that are typically home to higher yielding stocks will never pass through this screen because of the nature of the industry. For example, real estate investment trusts (REITs) by law must pass through as dividends the vast majority of their earnings—for this industry a measure similar to cash flow (funds from operations, to be specific) is a more appropriate gauge of dividend paying ability. Utilities are another industry that is not likely to have material representation on this screen. Those caveats aside, this screen can help identify both strong companies and strong dividends.
ACE Limited provides insurance and reinsurance services for a range of international clients. The company, which is headquartered in Switzerland, currently serves customers in over 170 countries. In 2011, the Net Premiums earned breakdown was as follows: North America (45%), Overseas General (37%), Global Reinsurance (7%), Life Insurance and Reinsurance (11%). The company offers multiple services that include claims and risk management products and services, pre-loss control services, as well as peril crop and crop/hail insurance. ACE mainly seeks expansion through a three-pronged strategy: an augmented product portfolio, deeper geographic penetration, and acquisitions.
The insurance outfit posted mixed results during 2012’s first quarter. Net premiums earned advanced slightly year over year, but the bottom line posted a significant increase versus a year ago. We anticipate substantial earnings increases because of higher policy prices in the United States. Further, customer retention and the procurement of new customer wins are at peak levels. Also, claims for catastrophe-related incidents have been low for the year, thus far.
The favorable scenario positions the company well to continue to pay a solid dividend payment to its shareholders. In fact, the board recently approved a 4% increase in the quarterly payout from $0.47 to $0.49. It appears that further increases are likely. Indeed, a growing international presence, strong reserves and ample cash should facilitate the focus on returning value to shareholders in the form of healthy dividend payments. All told, these shares suit income-oriented investors.
Safeway Inc. is one of the largest food and drug retailers in North America, with 1,678 stores at year-end 2011. The company’s North American operations are located in States that include California, Hawaii, Texas, and Washington. Safeway also operates 32 manufacturing and food-processing facilities that support its retail operations. In addition, it owns and operates GroceryWorks.com, an online grocery channel.
Near-term top- and bottom-line prospects appear bright for Safeway Inc. The favorable outlook is due, in part, to a new marketing initiative recently implemented by the retailer. The digital ''Just For U’’ marketing program allows SWY cardholders to receive online coupons and personalized deals which are aimed at facilitating higher volume growth, both online and in stores. Furthermore, an expanding gift card business and an overall healthier economic landscape should enable operating margin expansion. Solid growth platforms have allowed Safeway shares to be an attractive short- and long-term selection to investors with above-average appreciation potential for the 2015-2017 timeframe.
The company is also determined to give back to shareholders. Management recently approved a 21% quarterly dividend increase, to $0.175, which will be paid during the July period. Safeway has consistently implemented annual dividend increases since it initiated payouts in 2005. Thus, income-oriented investors may find the dividend yield attractive, which currently stands at around 3%, which is above the Value Line median. Our 3- to 5-year projected payout ratio also suggests an above-average yield, fueled by the company's ample cash generation prospects.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.