Performance Measure for Risk-to-Dividend

The continued challenges and slow down in various sectors of the economy is putting stress on dividends paid by many corporations. During year 2008 and so far in 2009, investors have had to experience dividend reductions and/or dividend cuts, thereby affecting their continued dividend income. My dividend portfolio was also affected by dividend elimination/reductions by C, BAC, and PFE. In order to minimize the risk of dividend reduction/elimination from each stock, I have been using the pre-determined maximum limit of 5% of total dividends. This method does not provide a means to measure the changes in risk-to-dividend on continued basis. Therefore, I have come up with the method that I have started using for my dividend portfolio. Here I am discussing a measure of risk-to-dividends, which can be used by individual dividend investors. To calculate any measure of risk-to-dividends, we first need to understand what are the factors or variables that will affect the payment of dividends. I believe current prices, profitability, payout factor, yield, year-over-year growth of EPS, and financial leverage are variables that will helps us measure the risk on continued basis.

Current Price (P): The current price of the stock reflects the general market opinion about the company and its fundamentals. The objective here is to capture the historically based fair value vs. the current pricing. As a part of my dividend stock analysis, I calculate the range of fair value of the stock. This range is based on average (with standard deviation) of five different measures. The range is calculated as [average fair value + (0.5 x Standard Deviation)]. If the current price of the stock is below this range, I assign it high risk (value of 3). A current price within this range is assigned moderate risk (value of 2). A current price higher than this range is assigned low risk (value of 1).

Current Yield (Y): The rationale for inclusion of yield is to gauge the corporation’s current yield with its historical range. I calculate the average yield and standard deviation for the last 10 years. The range is calculated as [average yield + (0.5 x Standard Deviation)]. If the current yield of the stock is below this range, I assign it low risk (1), within this range is assigned moderate risk (2), higher than this range is assigned high risk (3).

Current Payout factor (PF): It is always better to have a lower payout factor. The purpose of including payout factor is to measure how it differs from corporation’s historical average payout factor. I calculate the range of payout factor based on average payout factor and half standard deviation for last 10 years. ‘Current payout factor’ within this range is assigned moderate risk (2), higher than this range is assigned high risk (3), and lower than this range is assigned low risk (1).

Profitability (GM and OM): This includes corporation’s gross margins and operating margins. I calculate the range values based of 10 year average and its half standard deviation. Current margins lower than this range is assigned high risk (3), within this range is assigned moderate risk (2), higher than this range is assigned low risk (1).

Financial leverage (FL): The notion here is that corporation’s should effectively manage its debt. I calculate the average value and its standard deviation. The current value within this range is assigned moderate risk (2), lower is assigned low risk (1), higher is assigned high risk (3).

Growth of EPS (Delta EPS): The year-over-year growth of earnings is what will facilitate the growth in dividends provided corporation is able to maintain its profitability and low debt. Here, also I calculate the range based on average EPS growth rate and its half standard deviation. The current EPS growth within this range is assigned moderate risk (2), lower is assigned high risk (3), higher is assigned low risk (1).

Now the risk factor is calculated as arithmetic average of all these seven parameters.

Risk Factor = [P + Y + PF + GM + OM + FL + Delta EPS] / 7

The range of this risk factor is from minimum of 1 to maximum of 3. Since we are measuring three levels of risk (low, moderate, high), we can divide this into three equal parts. 1.00 to 1.67 is low risk, 1.68 to 2.34 is moderate risk, and 2.35 to 3.00 is high risk.

The key advantage of this measurement is that it measures the current risk profile to corporation’s own historical standard.

As an example, this excel sheet shows the risk analysis of Proctor and Gamble Co (PG). Similar following are calculated risk factor (i.e. risk-to-dividends) for few stocks in my dividend portfolio:

High Risk Category: GE (2.57), HCP (2.61)

Moderate Risk Category: JNJ (2.14), SYY (1.86), BP (1.86), INTC (2.13)

Low Risk Category: PG (1.43)

While I do not have any position in KMB (2.57), it is under high risk category.

Now that we have calculated this measure for risk-to-dividends, the next question is how to use it in dividend portfolio management process? The way I plan to use it is, stocks in high risk category will not receive new capital investments and are likely candidates for selling, stocks in moderate risk category and low risk category are ‘candidates for continued investments’.

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