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Subject 8. Analysis of Dividend Safety PDF Download
How to determine if a company's cash dividend may be cut?

The traditional ways is to look at the dividend payout ratio (dividend / net income) and its inverse, the dividend coverage ratio. The dividend payout ratio tells you what percentage of a company's net income is required to service or cover the dividend. The higher the ratio, the more likely of a dividend cut. If the payout ratio exceeds 100%, the dividend is simply not sustainable.

Unfortunately there is no ideal payout ratio. It varies both by industry as well as individual company. The target dividend payout ratios of large mature companies are usually between 40 to 60 percent. When evaluating a payout ratio, it's good idea to compare the current ratio to the company's historical ratio as well as ratios of other companies in the same or similar industries.

As a sign of caution, analysts should become suspicious of a company whose dividend payout ratio exceeds 60 - 70%. At that point, earnings only need to fall by 30 - 40% before dividends are no longer funded by earnings.

Free Cash Flow to Equity (FCFE) is cash available to stockholders after payments to and inflows from bondholders. The FCFE coverage ratio is another metric to analyze. A sustainable dividend policy requires the ratio to be significantly higher than 1.

Another important factor is the debt to equity ratio. If a company has lots of debt and a large portion of its cash earnings are paid in interest payments, this signals a high chance the dividend will be cut or it is not sustainable.

Learning Outcome Statements

calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow;

identify characteristics of companies that may not be able to sustain their cash dividend.

CFA® 2023 Level II Curriculum, Volume 3, Module 18

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