How do we know a dividend is safe?
It’s a question we get quite often and the reason why this comes up is because investors looking at Canadian dividend stocks are likely using traditional metrics in evaluating the safety of a dividend.
The “go-to” dividend metric may not tell the whole story
Case in point, the dividend payout ratio is the “go-to” metric for most investors. This calculation is pretty simple and is the ratio most publicized by data providers. The traditional dividend payout ratio looks at the safety of the dividend against earnings.
A ratio above 100% could mean that there is an impending dividend cut. While this may be true, in many cases comparing the dividend against earnings is not the most accurate indicator. Earnings contain many one-time and non-cash items that have no bearing on a company’s ability to pay a dividend.
Since the dividend is a cash outlay, non-cash items typically have no impact and one-time items are just that – one-time items that should not impact the long-term viability of the dividend.
This is not to say the traditional dividend payout ratio isn’t relevant and it certainly has its place. However, in certain industries it is best to compare the dividend against cash flows.
We can look deeper to properly evaluate a dividend
Getting to know these different metrics and how they relate to various industries is critical for any dividend investor, including those beginning to learn how to buy stocks.
Pipeline companies like Enbridge (TSE:ENB) are a great example of how the dividend can look unstable based on traditional metrics. As of writing, Enbridge has a payout ratio of 109% which is sure to raise some red flags for investors.
However, take a look at this chart and what do you notice? Enbridge has always had a high payout ratio.
So how has Enbridge successfully achieved 25-years of dividend growth, the sixth longest streak in Canada?
The answer is in the cash flows.
Pipelines are high capex industries which lead to higher costs, but they are typically financed through large debt loads. While this may seem risky, projects are usually underpinned by long-term contracts. Enbridge is no exception.
Enbridge has over 40 diversified sources of cash flow, 98% of which is backed by costs of service or long-term contracts. Furthermore, more than 95% of customers are investment grade and it is largely insulated from the price of commodities.
For years, the company has been reporting dividends against distributable cash flow (DCF), which is effectively adjusted cash from operations or operational cash flow (OCF). If you want the more formal definition:
DCF is defined as cash flow provided by operating activities before changes in operating assets and liabilities (including changes in environmental liabilities) less distributions to non-controlling interests and redeemable non-controlling interests, preference share dividends and maintenance capital expenditures, and further adjusted for unusual, non-recurring or non-operating factors.
That is a mouthful and many midstream companies have their own version of this cash flow metric. While it is a non-GAAP metric and not comparable across all companies, it is still a good barometer against which to measure the dividend.
In 2020, the dividend accounted for only 69% of DCF which is right inline with the company’s target (70%). Not only is the dividend safe, but since Enbridge has an ambitious $17B capital expenditure program, the company is still growing.
Through 2023, Enbridge expects to grow DCF by 5-7% annually, and in turn the dividend is expected to match annual DCF growth. This is great news for income investors.
Circling back to the question – is Enbridge’s dividend safe?
Not only is it safe, Enbridge remains one of the best income stocks to own on the TSX Index. It provides a high starting yield (6.71%), has a reliable history of performance, and is trading at a discount to historical valuations.
Now that we have looked at Enbridge, want to dive into another analysis? Is Labrador Iron Ore’s (TSE:LIF) Dividend Too Good to Be True?