Next week, a few adjustments will flow through to our Dividend Safety Scores to further improve their ability to identify companies that are most at risk of cutting their dividends in the future.
We expect these adjustments to make the scores even more thorough, timely, and accurate going forward.
However, these improvements will cause some companies to experience a score change.
Although the vast majority of companies will not see a material change in their risk classification, we want to keep you as informed as possible.
Members will receive an email early next week that lists any of their holdings that have experienced a meaningful score change, along with analysis explaining the reasoning behind the company’s new score.
In this article, we will do our best to outline the improvements we are making, address how different types of companies will be affected, and answer questions you likely have.
Our hope is help everyone understand the improvements being made, learn why the improvements are helpful, and remain very comfortable using our Dividend Safety Scores.
If it ain’t broke, why fix it?
The first question you might have is why we would tinker with our Dividend Safety Scores if they were already working fairly well.
After all, you can see that almost all dividend cuts that have been announced since we’ve been in business have come from companies with Dividend Safety Scores near 40 or below. You can see more details about our real-time track record here.
We want to make it clear that the underlying principles and scoring methodology we use will not change. We are not overhauling how Dividend Safety Scores work by any means.
All we are doing is incorporating some new insights and financial metrics that are now available in our database to help us further pinpoint dividend risk. We will review these new metrics shortly.
For now, the takeaway is that our scores will remain focused on the factors that have helped them be successful, and the new scores will be interpreted the same way as they always have:
As we mentioned earlier, we expect these changes to make our scores even more thorough and accurate while also reducing their volatility unless something has really changed with a business.
What’s the new data being incorporated?
Here are the new metrics our updated scores will make use of:
1) Forward payout ratios
A payout ratio expresses the percentage of a company’s earnings that have been paid out as a dividend.
Our Dividend Safety Scores currently calculate payout ratios by using company’s total earnings reported over the trailing 12-month period.
While this methodology works well to capture a snapshot of recent business conditions, it is not always a good indicator of where the company’s earnings are going in the future.
We now have access to analysts’ forward earnings estimates for thousands of companies. As a result, we can calculate a company’s projected payout ratio for the year ahead, identifying situations where a company’s dividend risk is expected to significantly increase or decrease and adjusting its Dividend Safety Score accordingly.
Our calculations will continue using trailing 12-month payout ratios as well since they reflect actual business results, but implementing a blended assessment of trailing and forward payout ratios will help us spot companies with changing risk profiles even sooner in many cases.
2) Cash flow metrics for REITs and MLPs
Real estate investment trusts (REITs) and master limited partnerships (MLPs) report unique financial metrics that are much more informative about their health rather than looking at earnings.
Specifically, REITs report funds from operations (FFO) and adjusted funds from operations (AFFO). You can learn more about these metrics here. FFO and AFFO are much better way to evaluate a REIT’s operating cash flow and free cash flow, respectively.
Our current scoring system does its best to estimate a REIT’s FFO by adding depreciation and amortization to net income, but this can be prone to errors (e.g. a REIT sells some properties, realizing a large gain). We also did not have a way to approximate AFFO.
Fortunately, our new data will have actual FFO and AFFO values at our disposal. We will use these metrics to calculate trailing and forward payout ratios and quarterly cash flow growth for REITs, providing much greater visibility into their dividend safety.
The story is similar for MLPs, which report distributable cash flow (DCF). DCF can be thought of as a free cash flow measure for MLPs (learn more here), with the main difference being that it excludes their spending on growth projects, which can be substantial.
We had been trying to estimate DCF by adding depreciation and amortization to net income. While this was better than nothing, it was far from ideal.
Now we have have actual DCF data for MLPs, which we will use for trailing and forward payout ratios, as well as quarterly DCF growth.
Simply put, gaining access to industry-specific cash flow metrics for REITs and MLPs is a big win for our scores and will help income investors navigate these high-yield areas of the market even more responsibly to reduce surprises.
3) Off-balance-sheet debt
Investors trying to size up a company’s financial leverage will typically look at ratios such as debt / EBITDA, debt-to-equity, or debt-to-capital.
Almost all of the time, the “debt” part of these ratios is taken straight from the firm’s balance sheet and reflects loans the company has taken out.
However, some companies have significantly more financial obligations than those printed clearly on the balance sheet. Unfunded pension debt and operating leases are two primary examples.
Unfunded pension debt is fairly straightforward – a company has a defined benefit pension plan and has promised to pay employees a certain amount of benefits each year after they retire. The company makes contributions to its pension plan which are invested to fund these benefit obligations.
Many times, a pension plan’s contributed assets are less than the expected value of benefits to be paid out in the future. Sometimes the difference is staggering, but unfunded pension debt is buried in footnotes of companies’ reports rather than on the balance sheet.
We are now able to capture any unfunded pension debt a company has and add it to their total debt when calculating various leverage metrics.
Operating leases are a bit trickier to understand. Some companies own the buildings, equipment, and property needed to run their businesses. Other companies will instead lease these assets, choosing to make periodic payments over a number of years instead.
Some of these arrangements are classified as operating leases. Leasing assets is a type of financing agreement, which puts the company on the hook for putting up the remaining lease payments in return for use of an asset.
However, operating lease liabilities do not show up on the balance sheet as debt. The company records rent expense relating to the operating leases, but that’s the extent of it.
Credit rating agencies will typically estimate a company’s total operating lease debt by applying a multiple to the firm’s annual rent expense. Our scores will now incorporate any off-balance-sheet operating lease debt by applying the same treatment and adding that figure to the company’s overall debt.
4) Non-GAAP earnings
Companies are required to report earnings based on Generally Accepted Accounting Principles (GAAP) when they file financial statements. However, many businesses will also report “non-GAAP” earnings, which adjust out one-time events, such as restructuring charges and non-cash impairments, to paint a truer picture of their operating performance.
It’s true that some “non-GAAP” earnings figures are controversial because they make a firm’s results look better than they perhaps should. However, non-GAAP earnings usually do a fair job of excluding noisy factors to better reflect a company’s underlying operations.
Our scores previously only had GAAP earnings at our disposal, which would periodically cause volatility if a company’s earnings shot up or down for accounting reasons that didn’t reflect actual corporate performance.
With non-GAAP earnings figures now at our fingertips, our scores will be able to exclude this noise to calculate more stable and realistic payout ratios, earnings growth, and more.
5) Uninterrupted dividend streaks
Many income investors like to know how many consecutive years a company has raised its dividend to gain confidence in its ability to continue safe dividends.
We used the length of a company’s dividend growth streak as a factor in our Dividend Safety Scores. However, there are many examples of companies that might not have a long dividend growth streak but have paid uninterrupted dividends without reduction for many decades.
We have cleaner dividend history data available now that better adjusts for trickier issues like stock splits and special dividends to identify these companies, which are now being rewarded more in our scoring system.
A long history of paying uninterrupted dividends is often a sign that the company’s business is managed conservatively and committed to its payout.
What types of companies are most affected by these improvements?
Generally speaking, REITs, MLPs, and consumer retailers experienced the most change, largely due to the inclusion of FFO / AFFO / DCF / off-balance-sheet debt (many retailers lease their properties) metrics.
Otherwise, score changes really depend on a company’s unique situation – Did they have a lot of off-balance-sheet debt that wasn’t being recognized before? Was their GAAP earnings noisy and over or understating payout ratios and growth? Was there a long uninterrupted dividend streak we were missing? Are forward earnings expected to significantly increase or decrease?
It’s worth repeating that the vast majority of companies will not see a material change in their risk classification. We just really don’t want you to be surprised when you see some scores shift around.
When is the Dividend Safety Score update taking place?
The update will take place early next week. We will send out an email when the score changes go live.
How will I know which scores changed significantly in my portfolio?
In the email we send out early next week, you will receive a list of any stocks in your portfolio that have seen their scores drop to a level that merits a review. Each flagged stock will be linked to a page of analysis you can read that explains the fundamental factors supporting its new score.
If you have any other questions, please leave a comment below or email us at firstname.lastname@example.org.
We know our Dividend Safety Scores are a very important part of the portfolio management process. While we are excited to make our scores smarter with these improvements, we also know change can be uncomfortable. We will be here for you every step of the way.