Sunday, May 17, 2009

Focus On ROE To Avoid Dividend Cuts

One certainty in this market is dividend paying companies are finding it palatable to cut their payout to investors.

graph of number of companies cutting dividendCharles Schwab & Co. (SCHW) recently issued a research report that evaluated a number of different financial factors and found companies that have higher ROE's (return on equity) are less likely to cut their dividend. Schwab reviewed the characteristics of dividend-paying stocks within the top 3,200 stocks by market capitalization, from 1990 through February 2009.

The result of the research noted:
  • A firm with high ROE is more likely to be able to generate income in excess of expenses and, thus, support its dividend.
  • To examine ROE’s ability to predict future dividend changes, SCHW calculated each dividend-paying stock’s trailing 12-month ROE at the end of each month from 1990 to February 2009. They then calculated each stock’s subsequent 12-month change in dividends at the end of each month, and used this change number to split their dividend-paying universe into three groups: those that cut dividends, those that raised them and stocks with no change. Then, they examined the success of ROE in identifying safer dividend payers.
  • What they found was stocks in the lowest 20% of ROE were twice as likely, on average, to cut dividends as the other 80% over the subsequent 12 months, as noted on the below chart.
percent of stocks that cut dividendThey also found that companies with a high ROE had more dividend increases.
  • Stocks in the top 20% of ROE increased dividends, on average, more than 60% of the time during the subsequent 12 months, as the chart below details.
percent of stocks that raised dividendIn the end, the research concluded, "investors could have minimized their risk of experiencing a dividend cut by focusing on dividend payers with higher ROE." They also found the higher ROE dividend payers had higher total returns compared to the dividend paying universe of 3,200 stocks.

Lastly, I recently wrote a post noting how ROE is a component of the dividend discount model (DDM). Although the dividend discount model may seem simplistic, when looking at the variables that are at play in this model, an investor will get a better understanding of the financial factors behind the DDM.


Are Your Stock Dividends Safe?
Charles Schwab & Co.
By: John Wightkin
April 13, 2009


Brad Castro said...

Great post and very insightful. Thanks for sharing the research and the solid presentation.

NoFreeCake said...

Interesting observation but how do you know when a company's ROE is within the bottom or top 20% of all other dividend payers?

I don't doubt Schwab did the proper crunching, but, how do I know the cutoff numbers if I chose to use this metric?

Any ideas? Thanks

NoFreeCake said...

Oh, nevermind. It occurred to me I could use my AAII database for that.

Note the Schwab article had an error. The article said they looked at the ROE ranks for all dividend paying companies. But, in their description of how you could use their stock screener to do this they said just use 20% of entire market. That's not the same as 20% of just dividend paying companies.

FWIW, my quick and dirty sort said an ROE of -19 or worse ranks in the bottom quintile. An ROE of 18 or better was the top quintile. Standard disclaimers apply :)

Given this, the Schwab article really isn't saying much. Who would expect to see dividend growth from ROE's that low?