Today, in the spirit of “teaching a man to fish,” I’m taking you behind the scenes to show you exactly how I determine the safety of a company’s dividend.

As far as I can remember, I’ve never outlined my full Safety Net criteria before, so I’m eager to share the details with you.

The first thing I look at is free cash flow.

I focus on free cash flow rather than earnings because earnings include all kinds of non-cash items and are easily manipulated.

For example, earnings can include revenue that has been recognized but not received. Let’s say a company books a $1 million sale on December 29. Those funds would count toward the company’s revenue for the year, and that revenue would then trickle down the income statement, with a portion of it being added to earnings.

However, the company sends the invoice on December 30 and, as of December 31, has not been paid.

That $1 million still counts toward the year-end revenue and earnings totals, but it won’t be reflected in free cash flow because the company has not received the money yet.

Another example is stock-based compensation. When a company grants stock to employees, it is counted as an expense that lowers earnings. But no cash went out the door, so it doesn’t affect cash flow.

In short, cash flow is how much cash the company actually brought in (or sent out).

When it comes to evaluating the safety of a company’s dividend, we want to see that the cash the company generated is enough to cover the dividend. That’s because dividends are paid in cash, not in “earnings.”

The best way to determine whether the cash is sufficient to cover the dividend is by calculating the company’s payout ratio, or the percentage of its free cash flow that it pays out in dividends. (Most people use earnings to calculate payout ratio, but I prefer free cash flow for the reasons I explained above.)

We calculate free cash flow by going to a company’s statement of cash flows and subtracting its capital expenditures from its cash flow from operations.

Below is McDonald’s‘ (NYSE: MCD) statement of cash flows from its 2023 annual filing with the SEC.

The key numbers we’re looking at are cash provided by operations, capital expenditures, and common stock dividends.

You can see that cash flow from operations was $9.612 billion and capital expenditures (sometimes known as “capex”) were $2.357 billion. To arrive at our free cash flow figure, we subtract capex from cash flow from operations. McDonald’s’ free cash flow comes out to $7.255 billion.

Then we look at common stock dividends, which totaled $4.533 billion.

This tells us that McDonald’s paid out $4.533 billion out of the $7.255 billion that it generated in cash. That’s a payout ratio of 62%.

If we’d used the $8.469 billion earnings figure (shown in the “net income” row at the top of the page) to determine the payout ratio, the payout ratio would’ve been 54%.

But remember, dividends must be paid in cash, so we’re not interested in what percentage of earnings the company paid out in dividends. We need to know what percentage of its cash was paid out in dividends.

In Safety Net, my payout ratio threshold for most companies is 75%. If the payout ratio is above 75%, I no longer have confidence that the company could afford its dividend if it were to hit a rough patch or its cash flow were to decline. But if the payout ratio is below 75%, the company has a decent buffer to protect it if it has a bad year.

However, there are some exceptions to my 75% rule. I allow real estate investment trusts (REITs), business development companies (BDCs), and partnerships to have payout ratios of up to 100% because they are legally required to pay out 90% of their earnings. For that reason, they usually have higher payout ratios than other companies.

Also, we use a different measure of cash flow for these types of companies. For REITs, we use funds from operations (FFO), for partnerships, we use distributable cash flow (DCF), and for BDCs, we usually use net investment income (NII). For banks and mortgage REITs, we use net interest income.

When I’m determining my Safety Net grades, every stock starts out with an “A” rating and then gets downgraded depending on several factors.

Safety Net looks at both the previous year’s payout ratio and the current year’s expected payout ratio. The stock gets downgraded for each one that’s above 75% (or 100% for REITs, BDCs, and partnerships).

This year, McDonald’s’ payout ratio is forecast to drop from 62% to 53%, which is still well below my threshold.

I also look at cash flow growth. If cash flow has declined over the past year or past three years or is expected to fall in the current year, the stock’s safety rating will be downgraded.

McDonald’s had a big jump in free cash flow in 2023, so its one- and three-year growth rates were positive. Free cash flow is forecast to increase this year as well.

Lastly, we look at the company’s dividend-paying track record over the last 10 years. For each dividend cut in that span, the dividend safety rating gets downgraded by one level. If the company has raised its dividend in each of the last 10 years, it will get a one-level upgrade, because that tells me that management is committed to sustaining the dividend even if the financials get troublesome.

McDonald’s has no dividend cuts in the past 10 years. In fact, it has raised the dividend every year for the past 49 years, so it gets a bonus point.

To sum it up, each stock begins with an “A” rating and a score of 0, but its grade is adjusted based on the following factors:

• Previous year’s payout ratio above 75% (or 100% for REITs, BDCS, and partnerships): -1
• Current year’s expected payout ratio above 75% (or 100% for REITs, BDCS, and partnerships): -1
• Negative cash flow growth over the past year: -1
• Negative cash flow growth over the past three years: -1
• Negative expected cash flow growth over the next year: -1
• Dividend cut within the past 10 years: -1 per cut
• 10 years of consecutive dividend increases: +1.

If the company ends up with a score of 0 or 1, it gets an “A.” If its score is -1, it gets a “B.” A score of -2 earns a “C” grade, a score of -3 gets a “D,” and a score of -4 or below gets an “F.”

McDonald’s’ payout ratio was within my comfort zone last year and should remain there, its free cash flow has been growing and is expected to continue growing this year, and it has no history of dividend cuts in the past 10 years.

With no downgrades, the stock gets an “A” for dividend safety.

Now you know how the Safety Net sausage – or, in this case, Sausage McMuffin – is made. But feel free to continue letting me know what stocks you’d like me to analyze here in Safety Net. Just leave the ticker symbols in the comments section below.

Dividend Safety Rating: A

The post The Safety Net System: How I Evaluate Companies’ Dividends appeared first on Wealthy Retirement.

The truth is, many of the market’s top executives get distracted chasing the wrong metrics for success.

That’s why Chief Income Strategist Marc Lichtenfeld wants investors to avoid making the same mistake.

Instead of following the faulty metric Jody describes below, take a look at Marc’s March interview in U.S. News & World Report to discover which signals will best guide your portfolio.

>Click here to read the full interview.<

– Mable Buchanan, Assistant Managing Editor

Nearly 20 years ago to this day, my beautiful soon-to-be wife and I sat down on a plane in Winnipeg, Manitoba.

Our destination?

Bermuda, where we would eventually live for eight years after landing the jobs we were headed to interview for on that very trip.

I’m sure you can understand why we were interested in escaping Manitoba winters for a few years. The average daily low temperature in Manitoba in January and February is minus 4 degrees Fahrenheit.

(That is the average. On many days, it gets much colder!)

After sitting down in my seat, I pulled out the book I was reading at the time.

It was The Warren Buffett Way by Robert Hagstrom, a book that details the business and value investing principles practiced by the great investor.

The passenger sitting in the aisle seat beside me took one look at the cover and scoffed, “What are you bothering reading that for? The stock market is so simple. You just buy low and sell high!”

He wasn’t making a joke. He really believed that investing was that easy.

Technically, he was correct, although anyone who has invested in the market knows it is much harder than that. A stock that you think is low can often go a lot lower, and a stock that you think is high might never be that low again.

Looking back, I don’t think it was a coincidence that our conversation occurred within weeks of the peak of the dot-com bubble in 2000. I would imagine that his view of how simple investing was changed shortly thereafter.

But his simple advice does have some value to it…

Has Corporate America Heard This Man’s Advice?

It frustrates me endlessly.

When the stock market and economy are both booming, publicly traded companies repurchase their shares like it is going out of style.

Over the past three years, the companies that make up the S&P 500 Index spent more than $2 trillion buying back their own shares. Over that time period, corporations were buying back so much stock that they were the single largest source of demand for American stocks.

Let me be clear – I do not have a problem with companies repurchasing their shares. In fact, when done intelligently, share repurchases are a powerful tool for creating value for shareholders.

The problem is that corporate America does not repurchase shares intelligently. Quite the opposite…

These companies are most aggressive with their buybacks at the worst possible times. Because they repurchase their stocks most aggressively when the economy and markets are booming, they make those repurchases when their stock prices are high.

Instead of buying low, corporate America buys high.

Then, when economic difficulty hits and share prices slump, these companies stop buying back shares. Sometimes the same companies that were repurchasing shares at high prices end up issuing shares at low prices after the market has tanked.

Brutal…

Goldman Sachs just released a report that indicates that share repurchases are expected to decline by 50% to $371 billion during 2020.

Companies like McDonald’s (NYSE: MCD), AT&T (NYSE: T), Nordstrom (NYSE: JWN) and all of the big banks have completely suspended their repurchase programs even though their share prices are down.

The reason these companies have to stop repurchasing shares when their shares are actually great bargains is because they spent all their money repurchasing shares when stock prices were much more expensive.

This isn’t rocket science, folks…

All that needs to happen is for companies to have a little patience when the economy is good and stock prices are high. They should let cash build and wait for a better opportunity.

Share repurchases aren’t meant to be the default option for companies to use excess cash on when they don’t know what else to do with it. Share repurchases are meant to be done opportunistically when a share price actually represents good value.

The corporate boards of these companies need to think like investors when spending cash on share repurchases. Buy when there is value, not just when cash is most available.

We can teach them this by handing them a copy of The Warren Buffett Way…

Or we can just get my seatmate on that flight out of Winnipeg 20 years ago to explain it to them.

Good investing,

Jody

P.S. Recently, Chief Income Strategist Marc Lichtenfeld gave away three of his favorite dividend payers in a special video…

And now Chief Trends Strategist Matthew Carr from our sister e-letter Profit Trends is raising the ante.

Tomorrow, we’ll hear from Matthew on one of the sectors that excites him most today – and if you keep your eyes peeled, he’ll even reveal details on one of Profit Trends’ favorite stocks for free.

The post What CEOs Don’t Get About Share Buybacks appeared first on Wealthy Retirement.

U.S. stocks slipped last week, and global markets tumbled Monday amid growing concern about a new strain of coronavirus and its potential to derail the global economy.

Before going further, I acknowledge it is grotesque to discuss money when people’s lives are in danger. But it’s important to understand that the market doesn’t exist in a vacuum, and when crises hit around the world there is bound to be financial fallout as well.

The death toll from the outbreak hit 80 on Sunday in China, where more than 2,800 cases have been confirmed by local authorities so far.

As of this writing, five cases of coronavirus have been confirmed in the U.S. Several other countries have confirmed at least one case, including France, Australia, Canada, South Korea and Thailand.

According to the World Health Organization, 90% of the coronavirus patients outside of China had traveled through Wuhan, where the disease started.

In an effort to stem the disease’s spread, China has restricted travel for nearly 50 million of its citizens. For perspective, that’s roughly the same amount of people who live in the Boston-to-Washington corridor.

This comes as bad timing when China’s weeklong Lunar New Year started Saturday. Traditionally, it’s a time when millions of Chinese citizens travel to visit friends and family. But Chinese officials are limiting travel in an effort to stem the spread of the disease.

Over the weekend, Chinese President Xi Jinping warned the country is facing a “grave situation” due to the “accelerating spread” of coronavirus.

Xi’s admission was refreshing for its candor. But it also rattled global investors.

China’s economy is the world’s second largest, and it’s already hurting from the trade war with the U.S. And when the Chinese economy suffers, it has ramifications across the globe.

Analysts estimate the 2003 SARS outbreak cost the global economy $40 billion. The economic impact from coronavirus could be far worse because China’s economy is even more important to the global one now than it was then.

Also, the Hubei province where Wuhan sits is an important hub of global commerce.

According to Bloomberg, 44 U.S. companies and 40 European firms have manufacturing facilities in the region, including PepsiCo (Nasdaq: PEP), Honda Motor Company (NYSE: HMC) and Germany’s Siemens (OTC: SIEGY).

Here’s a glimpse at the business fallout so far:

• The Walt Disney Company (NYSE: DIS) is closing its theme park in Shanghai.
• McDonald’s (NYSE: MCD) is closing locations in five cities and checking employees’ health in other areas. Starbucks (Nasdaq: SBUX) is also closing some locations.
• Wynn Resorts (Nasdaq: WYNN) is screening guests at its Macao casino for fevers and has local employees wearing protective masks.
• United Airlines (Nasdaq: UAL) has been “coordinating closely with the CDC to ensure that [it’s] taking all the necessary steps to ensure that [its] customers and employees can travel safely,” CEO Oscar Munoz said on a January 22 conference call.

In addition, France’s Rémy Cointreau (OTC: REMYY) pulled its 2020 earnings guidance because of the uncertainty surrounding coronavirus. “Clearly we are concerned,” Chief Financial Officer Luca Marotta said on a conference call. “We do not have any scenarios on a quantified basis. It is evolving hour after hour.”

The saying “the market hates uncertainty” is a cliché for a reason. The unpredictable nature of a disease like this in a tightly connected global economy is certainly cause for concern.

That said, odds are that global health officials will get coronavirus under control sooner rather than later. Judging by recent history, the economic and market impacts of the outbreak will also be contained.

Starting with the 1981 HIV/AIDS epidemic, HORAN Capital Advisors analyzed more than a dozen global epidemics. They found the MSCI World Index was higher on average one, three and six months after the outbreaks started.

The 2014 Ebola outbreak was the worst in terms of market performance, with the index falling 11.8% in three months. But even amid that global scare, the index rebounded sharply and was down only 2% after six months.

As I explained last week, a 5% to 10% correction would be normal given the market’s spectacular gains last year – not to mention in the past decade!

The coronavirus scare may prove to be a trigger for such a decline. But it’s one that will likely prove to be temporary, even a buying opportunity.

Furthermore, there is money to be made by any company that can provide an antidote to coronavirus or otherwise relieve suffering. With this in mind, “Drugmakers are hustling to make a vaccine,” USA Today reports.

For example, AbbVie (NYSE: ABBV) said China is testing its HIV drug Aluvia as a potential treatment. Novavax (Nasdaq: NVAX) surged last week after announcing it is working on a vaccine.

Other names speculators are eyeing include Gilead Sciences (Nasdaq: GILD) and BioCryst Pharmaceuticals (Nasdaq: BCRX).

These companies’ swift response shows that both medical professionals and the market will be able to manage the challenges that come with the coronavirus outbreak. And just like our population, the economy will recover stronger.

Good investing,

Aaron

The post The Real Impact of Coronavirus appeared first on Wealthy Retirement.