Is Your Stock's High Yield Safe and Sustainable

During periods of market turmoil you’ll often hear media pundits advise you to buy shares with high yields. The reasoning is that people will be less prone to sell stocks that deliver better-than-CD rate payouts than non-dividend payers. We also hear that dividends have provided a significant portion of historical total returns. Both the preceding statements are true.

The question every investor needs to ask is…“Is this stock’s payout reasonable based on the company’s fundamentals?” Here’s how to know that answer.

Every profitable firm has earnings per share that represent the amount they made after all corporate expenses and taxes. Companies have capital spending needs that must be paid for to fuel expansion or simply to keep competitive. To be fiscally prudent only the net amount of EPS less cap-ex should be considered available for other uses such as dividends or share buybacks.

Think of your own family as a corporation. Imagine you earned $100,000 in salary last year, paid $40,000 in state, local and federal taxes and needed $10,000 to fix a leaky roof. Your EPS would be $60,000 divided by the number of members in your family. If you had a non-working spouse and two kids your EPS = $15,000. Subtract $2,500 per share for capital expenses and you’d be left with $12,500 per share to allocate.

As CEO of your company you could declare a dividend of from zero to $12,500 per share, without borrowing to do so. Anything less than the maximum would allow your company to bank some cash (retained earnings) for the future. A payout greater than $12,500 per share would require deficit spending.

Here are comparisons of two food industry companies and their choices for allocating their earnings (per share) over the last few years.

Coca-Cola's (KO) management has done a superb job of raising the dividend more or less in line with EPS growth. This is a reasonable and sustainable payout for a mature growth company.

B&G Foods (BGS) came public in 2007 and proceeded to pay out well over 100% of the reported earnings in 2007–2009 and more than 100% of EPS less capital expenses in 2010. The company thus had to borrow money to pay those dividends -- an unwise cash management practice. It has about $478 million in total debt -- about 67% of total capital.

The nominal dividend is not secure or prudent in light of BGS’s high debt level. This reminds me of the many struggling banks that clung to their historical dividend rates prior to 2008’s credit crisis. Later they were forced to raise equity at punitive prices when they could have simply kept those millions of dividend dollars as retained earnings.

I am not predicting BGS will be forced to cut its payout. Perhaps its EPS will grow faster than the dividend. Owners of BGS should be aware of the risk they are taking. If the quarterly distribution does get reduced the shares may sell off dramatically.

At the time of publication, Gabriel Fancher held no positions in the stocks or issues mentioned.