Is your stock paying you too much?

Do due diligence on the payout ratio.

(Photo: Carl Pendle/Getty)

(Photo: Carl Pendle/Getty)

On February 7, BCE investors got some good news: the company announced it was hiking its dividend for the second time in a year. It’s now paying stockholders $0.5825 per share, or a 5.18% yield. Not too shabby, especially considering that a 10-year Government of Canada bond pays about 2%. But some people may be wondering if the yield is too high; the average yield on the S&P/TSX Composite Index is about half what BCE is paying.

The short answer: it’s not too high. The company is growing profits and earnings and its payout ratio—the percentage of earnings paid to shareholders in dividends—is around 65%. That’s attractive as it still has plenty of room to continue paying dividends if for some reason earnings fall.

While BCE may be a solid dividend play, investors should always be conscious of overreaching payouts, especially in today’s search-for-yield world. Leslie Lundquist, co-lead manager of the Bissett Canadian High Dividend Fund, says that while you can’t make a blanket statement that a particular yield is too high, it’s a good idea to do some additional due diligence if a company is paying 7% to 10% or higher.

To figure out if a company is paying too much, Lundquist suggests getting a sense of how much money a company needs to reinvest in a business. If it requires a lot of cash, then it could be forced to cut its dividend.  Also look at payout ratio—generally, you don’t want to see a company paying out 100% of its earnings in dividends—and buy companies that are growing earnings and revenues. Naturally, growing companies can sustain payments better than businesses that are seeing fortunes fall.

A crashing stock price will also push yields higher, so if you see something with, say, at 10% payout—that’s on the high range—be sure the share price isn’t plummeting.

The worst-case scenario for investors, says Lundquist, is a dividend cut. This happens if a business simply can’t sustain the payout anymore. Often, if earnings fall, the dividend will have to be slashed to free up cash to fund new projects, pay down debt, or simply stay in business.

Not only will you now receive less regular income, but typically the share price will fall either before or after dividends get cut, too. In other words, you’ll be out a lot of money.

As nasty as a dividend cut is, you may not want to abandon a hard-on-its-luck company. If its other fundamentals are still sound, a slash could be just what the business needs to get its house in order. Look at a company like bus manufacturer New Flyer Industries (TSX: NFI), one of Lundquist’s holdings. It had a rough road during the recession as U.S. municipalities, its main clients, stopped spending. It had to cut its dividend last summer, and while its price fell slightly at that time, it’s up 17% year-to-date.

The takeaway? Find out why the yield is so high before buying—and selling. If the business looks like it has no hope then dump before the dividend cut; if it just needs a retooling then the short-term pain could lead to great long-term gains.