If you’re an income investor, there’s one piece of news you never want to hear…
That a company in your portfolio is cutting its dividend.
Not only does it reduce your income… it’s also a “canary in the coalmine” about the company’s overall health—and an indicator that the stock could soon start tanking.
Fortunately, there are signs you can watch out for to help identify whether a company will be cutting its dividend soon. We’ll highlight these red flags today.
But first, let’s take a look at why dividend cuts are a huge red flag for any company.
Why dividend cuts are a death knell
Companies will typically do anything to avoid cutting their dividend.
That’s because it sends a negative message to Wall Street. It indicates that the business is deteriorating sharply… to the point that the company can’t fulfill its obligations.
Put simply, dividend cuts are a last resort for companies. In fact, some will even borrow money to keep their payout steady rather than cut it.
Data from McKinsey shows it’s extremely rare for a large, established company to cut its dividend without deteriorating conditions. According to McKinsey, from 1997 through 2021, just 29% of the 1,225 dividend-paying companies in the study cut their dividend. That works out to an average of 2% of companies per year.
Digging deeper, you’ll see that almost all of these cuts happened when a company saw a profit decline of at least 20%… an economic crisis… or both.
As you would expect, dividend cuts increase when the economy deteriorates. For example, during the recession of 2020, the number of dividend cuts/eliminations jumped to 16%—eight times higher than the 2% average.
And when a company cuts its dividend, it usually sends its shares plunging.
The good news is that there are a few major warning signs investors can look for—to help avoid buying one of these troubled companies…
1. A payout ratio above 100%
The most important metric for income investors to watch is the dividend payout ratio.
In short, this number measures how much of a company’s profit is being used to pay its dividend.
Payout ratio = total dividends / net income.
Income investors want this ratio to be relatively low, since a lower number means the company has plenty of profit left after paying its dividend. By contrast, a higher number leaves the company with less room to raise its dividend or invest in new growth projects.
Simply put, the payout ratio measures whether a company can afford its dividends.
When the payout ratio exceeds 100%, it means the company is paying out more (in dividends) than it’s making in profits.
Be sure to keep an eye on the payout ratio of every dividend-paying stock in your portfolio. If this metric goes above 100% (or dips below 0% due to negative net income), it’s a major warning sign that the dividend is too high compared to the company’s profits.
That brings us to our next red flag…
2. Declining profits
Sharply slowing—or, worse, declining—profits are another important warning sign to watch for.
Earnings are the lifeblood of a good income investment. If a company’s profits are heading in the wrong direction, it typically means it will have to cut expenses. And dividends are often the ultimate target.
For instance, Walgreens, which benefited significantly from COVID, started to struggle as the pandemic faded. Its net income went negative by the end of 2020… and dipped even further into the red by early 2023. Put simply, WBA’s dividend wasn’t sustainable after multiple quarters of losing money. It was ultimately forced to cut its dividend in January 2024.
3. Worsening debt trends
The last red flag involves a company’s debt load…
Generally, the more a company owes, the higher its interest payments… which add a nonnegotiable, long-term expense to its balance sheet.
This leaves companies with less profits to fund their dividends.
The bottom line
A payout ratio above 100%… slowing or falling profits… or sharply higher debt are critical warning signs that a dividend cut could be coming soon.
If you rely on dividends as part of your income stream, it’s important to check your portfolio’s health often—and watch for these red flags.
