dividend-sustainability-checks — evaluating investments

The practical point: You don't need to guess if a dividend will be cut—companies with payout ratios above 80% have a 3.2x higher probability of cutting dividends within 5 years than those below 60% (DeAngelo et al., 2008). A simple 4-metric screen (payout ratio, FCF coverage, leverage, earnings stability) flags unsustainable dividends before they fail.

Why Dividend Sustainability Checks Matter

You buy a stock for its 6.5% dividend yield, planning to rely on that income for retirement. Two years later, the company cuts the dividend by 75%, and your annual income drops from $6,500 to $1,625 on a $100,000 position. Not because you picked a "bad company"—because you screened for yield without checking whether the dividend was actually sustainable.

(DeAngelo et al., 2008) show that companies with payout ratios exceeding 80% of earnings cut dividends 3.2x more frequently within 5 years than those maintaining ratios below 60%. (Fama & French, 2001) demonstrate that firms with free cash flow coverage below 1.0x cut dividends 47% of the time within 3 years, versus 8% when coverage exceeds 1.5x. The mechanism: dividends funded by debt or unsustainable earnings ratios collapse when earnings decline or credit tightens.

The point is: Dividend sustainability checks fail when they rely on yield alone—"This stock pays 8%, so it must be safe." They succeed when they screen four metrics: payout ratio (target <70%), FCF coverage (target >1.5x), debt-to-EBITDA (target <3.0x), and earnings stability (target CV <0.25).

The durable lesson: High dividend yields don't guarantee income security. Sustainable dividends come from companies that fund payouts from recurring cash flow while maintaining credit-compatible leverage—conditions you can verify with four quantified checks before investing.

What Dividend Sustainability Is

Dividend sustainability is the capacity to pay the current dividend (and, if applicable, grow it) using recurring cash generation while maintaining solvency metrics that keep creditors senior to equity distributions. In the canonical dividend-setting model, managers target long-run payout ratios near 50% and adjust dividends toward those targets at 30%-35% per year (Lintner, 1956). This implies that abrupt changes are atypical unless fundamentals shift materially.

The practical definition: A dividend is "sustainable" when (1) the earnings payout ratio remains within a threshold band, (2) the FCF coverage remains above a minimum band, (3) leverage and interest coverage remain within credit-compatible ranges, and (4) earnings volatility stays below a quantified stability threshold.

The Four-Metric Screening System

The point is: You don't need to analyze every line item. These four metrics capture the sustainability risk. Run them in sequence: payout ratio → FCF coverage → leverage → earnings stability. If all four pass, the dividend is likely sustainable. If any fail, you need to understand why before investing.

1) Payout Ratios (Why Earnings Matter)

The calculation: Payout Ratio = (Dividends per Share / Earnings per Share) × 100.

What the thresholds mean:

Below 50%: Conservative buffer (aligns with the 50% long-run anchor in Lintner's model). This leaves room for earnings volatility without threatening the dividend.
50%-70%: Moderate band for mature issuers with stable earnings. Acceptable if other metrics are strong.
Above 70%: Elevated risk—requires FCF validation. The company is distributing most of its earnings.
Above 100%: Dividend exceeds earnings. The company is funding payouts from debt or asset sales (not sustainable).

The quantified risk: Payout ratios exceeding 80% of earnings correspond to 3.2x higher dividend-cut likelihood within 5 years compared with ratios below 60% (DeAngelo et al., 2008).

The warning signal: A move from 49% to 74% payout is a 25 percentage-point expansion. Flag any payout ratio increasing more than 15 percentage points over 3 years without earnings growth—this suggests the dividend is growing faster than profits can support.

2) Free Cash Flow Coverage (Why Cash Matters More Than Earnings)

The calculation: FCF Coverage = (Operating Cash Flow − CapEx) / Total Dividends.

What the numbers mean:

Above 1.5x: Strong cushion. The company generates $1.50 in free cash for every $1.00 paid in dividends. This is the sweet spot—low cut frequency (only 8% cut within 3 years; Fama & French, 2001).
1.0x-1.5x: Viable but watch closely. The dividend is covered, but there's little margin for error. Only works if earnings and capex are stable.
Below 1.0x: Red flag. The dividend is not covered by FCF. The company is funding payouts from debt or asset sales—this pattern fails 47% of the time within 3 years (Fama & French, 2001).

The critical warning: If dividends exceed FCF for 2+ consecutive years while long-term debt increases, the dividend is being "funded by debt" rather than operations. This is unsustainable—the company is borrowing to pay shareholders.

3) Debt Metrics (Why Leverage Threatens Dividends)

The leverage calculation: Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization.

What the thresholds mean:

Below 3.0x (industrials): Investment-grade territory. Creditors are comfortable, so dividends are less likely to be restricted.
Below 4.0x (utilities): Sector-adjusted line. Utilities can carry more debt due to stable cash flows.
Above 4.0x: Danger zone. The company should prioritize deleveraging over dividend growth. During the 2020 downturn, companies with debt-to-EBITDA above 3.5x were 4.1x more likely to suspend dividends compared with ratios below 2.0x (Moody's Investors Service, 2023).

The interest coverage test: EBIT / Interest Expense. This measures how many times earnings cover interest payments.

Above 8.0x: Preferred band. Strong coverage means the company can service debt comfortably even during stress.
Above 4.0x: Minimum acceptable. Below this, debt service becomes a priority over dividends.
Below 4.0x: Red flag. During the 2020-03 to 2020-06 FTSE 100 suspension wave, companies with interest coverage below 4.0x cut dividends 78% of the time versus 29% for those above 8.0x (Link Group UK Dividend Monitor Q4 2020).

The point is: When leverage is high, creditors get paid first. Dividends get cut when cash is tight.

4) Earnings Stability (Why Volatility Breaks Dividends)

The stability calculation: Coefficient of Variation (CV) = Standard Deviation of Earnings / Mean Earnings over 10 years.

What stability means:

CV below 0.25: Stable earnings. The company generates consistent cash flow, which supports consistent dividends. Dividend Aristocrats (companies with 25+ consecutive years of dividend increases) exhibit earnings volatility of 18% versus 31% for the broader S&P 500 (Standard & Poor's, 2024).
CV above 0.25: Volatile earnings. When earnings swing, dividends become vulnerable during downturns.

The recession test: Did earnings decline less than 20% during 2008-2009 or 2020 recessions? If yes, the company has defensive characteristics. If no, the dividend is at risk during the next downturn.

The dividend growth warning: Dividend increases above 25% in a single year were followed by dividend cuts 23% of the time within 4 years, versus 11% for increases below 10% (Benartzi et al., 1997). Aggressive dividend growth often reflects temporary earnings peaks, not sustainable profit growth.

The point is: Stable earnings → stable dividends. Volatile earnings → volatile dividends (or cuts when earnings collapse).

When Dividends Fail (Historical Stress Cases)

General Electric (GE) — 2017-11-13

Action: Quarterly dividend cut from $0.24 to $0.12 per share (−50%), the first cut since 2009.
Before metric: 2017 dividend payout reached 167% of free cash flow, versus industrial peers averaging 45% FCF payout.
Outcome metric: Stock declined 42% in the 12 months following the announcement; $8 billion annual dividend savings redirected to debt reduction.

Kinder Morgan (KMI) — 2015-12-08

Action: Quarterly dividend cut from $0.51 to $0.125 (−75%).
Before metric: Debt-to-EBITDA at 5.6x versus an investment-grade threshold of 4.5x.
Peer comparison metric: Enterprise Products and Magellan maintained leverage below 4.0x and preserved dividends.
Outcome metric: Stock fell 62% from the August 2015 peak; credit rating downgraded from BBB to BBB-.

FTSE 100 — 2020-03 to 2020-06

Action: 44 of 100 companies cut or suspended dividends during the initial COVID-19 shock window.
Coverage split metric: Interest coverage below 4.0x corresponded to 78% dividend cuts versus 29% above 8.0x.
Aggregate outcome metric: Total FTSE 100 dividends fell £35 billion (−41%) from £85 billion (2019) to £50 billion (2020).

Worked Example: Choosing Between Two Dividend Stocks

Your situation: Age 58, investable assets $450,000, time horizon 15 years, annual income requirement $18,000. You're evaluating two dividend stocks: Johnson & Johnson (JNJ) and AT&T (T). Both offer attractive yields, but which one is more sustainable?

The point is: This example shows you how to apply the four-metric screen to make an actual allocation decision.

Step 1: Check payout ratios

You calculate: JNJ dividend $4.96 / EPS $10.05 = 49% payout ratio. AT&T dividend $1.11 / EPS $1.89 = 59% payout ratio (post-2022 cut). Both pass the <70% threshold, but JNJ is more conservative.

Step 2: Check FCF coverage

You calculate: JNJ FCF $19.8B / dividends $11.8B = 1.68x coverage. AT&T FCF $16.8B / dividends $8.0B = 2.10x coverage. Both exceed the 1.5x target, but AT&T has stronger coverage.

Step 3: Check leverage

You find: JNJ debt-to-EBITDA 1.4x with AAA credit rating. AT&T debt-to-EBITDA 3.1x with BBB credit rating (just 0.1x above the 3.0x industrial screening line). JNJ wins decisively here.

Step 4: Check earnings stability

You calculate: JNJ 10-year earnings CAGR 6.2%; earnings CV 0.12 (well below the 0.25 stability ceiling). AT&T 10-year earnings CAGR −2.1%; earnings CV 0.48 (almost double the 0.25 ceiling). JNJ has stable earnings; AT&T has volatile earnings.

Step 5: Make the allocation decision

You need $18,000 annual income. You allocate $300,000 to JNJ at 3.1% yield = $9,300 annual income. You allocate $150,000 to AT&T at 6.5% yield = $9,750 annual income. Combined income = $19,050, which exceeds your requirement by $1,050 (a 5.8% buffer).

Why this allocation? JNJ gets 2:1 weighting despite lower yield because it has superior sustainability metrics (lower leverage, stable earnings). AT&T offers higher yield but higher risk.

The three scenarios:

Baseline: Both companies maintain current dividend growth. Year-5 income $22,400 (JNJ $11,900; AT&T $10,500); portfolio value $520,000 (a $70,000 gain, or +15.6%).
Good: AT&T deleverages successfully, resumes 4% dividend growth. Year-5 income $24,800 (JNJ $11,900; AT&T $12,900); portfolio value $580,000 (+$130,000, +28.9%).
Poor: AT&T cuts dividend 30% due to competitive pressures. Year-5 income $18,700 (JNJ maintains $11,900; AT&T reduced to $6,800); portfolio value $440,000 (−$10,000, −2.2%) with AT&T position declining 25%.

The durable lesson: Even with a 2:1 weighting toward the safer stock (JNJ), the higher-yield, higher-risk position (AT&T) can still hurt you if it cuts. The four-metric screen helps you size positions appropriately based on sustainability risk, not just yield.

Common Mistakes (And How to Avoid Them)

Mistake #1: Chasing yield without coverage checks

You see a 9.8% yield and think "this is great income." But you don't check whether the dividend is sustainable. Lumen Technologies offered 9.8% yield in early 2022; the company eliminated the dividend in November 2022, removing $1.40/share annual income and coinciding with a 35% stock decline.

The fix: Exclude yields exceeding sector average by >50% unless FCF coverage is >1.5x and debt-to-EBITDA is <3.0x. High yields often signal high risk, not high opportunity.

Mistake #2: Applying cross-sector payout thresholds

You use a 50% payout ratio threshold for all stocks. But REITs must distribute 90% of taxable income by law. Using an industrial 50% payout rule would misclassify Realty Income at 76% AFFO payout despite a 29-year dividend growth streak.

The fix: Use sector-specific bands: Industrials 35%-50%, Utilities 60%-75%, REITs 70%-85% of funds from operations. Different sectors have different payout norms.

Mistake #3: Relying on dividend history without forward metrics

You see a 15-year dividend payment history and assume it's safe. But SVB Financial had a 15-year dividend payment history and suspended dividends in March 2023, 48 hours before FDIC receivership. History doesn't predict the future when fundamentals deteriorate.

The fix: Track quarterly interest coverage >3.0x and, for banks, CET1 >10%, alongside explicit management payout guidance. Monitor forward-looking metrics, not just historical patterns.

Implementation Checklist

Essential (high ROI): Run these four checks before investing in any dividend stock.

Compute earnings payout ratio
- Flag: <50% (conservative), 50%-70% (moderate), >70% (elevated risk), >100% (red flag)
Compute FCF coverage
- Require: ≥1.5x (strong)
- Watch: 1.0x-1.5x (viable but monitor)
- Fail: <1.0x (unsustainable)
Check leverage
- Target: debt-to-EBITDA <3.0x (industrials) or <4.0x (utilities)
- Red flag: >4.0x (deleveraging priority)
Check interest coverage
- Minimum: >4.0x
- Preferred: >8.0x

Additional checks (when time permits):

Measure 10-year earnings stability
- Target: CV <0.25
- Flag: CV ≥0.25
Stress-history check
- Verify: earnings drawdown <20% in 2008-2009 or 2020 windows
Warning signals
- Payout ratio expansion >15 percentage points over 3 years
- Dividend > FCF for 2+ years
- Single-year dividend increase >25% (Benartzi et al., 1997)

The durable lesson: A dividend screen that enforces <70% earnings payout (unless FCF coverage is ≥1.5x), keeps leverage below 3.0x, and maintains interest coverage above 4.0x targets the same conditions associated with materially lower cut frequencies in the empirical record (DeAngelo et al., 2008; Fama & French, 2001; Moody's Investors Service, 2023).

The point is: Yield is a single input. Sustainability is a 4-metric constraint system with explicit cut-rate asymmetries: 47% vs 8% (FCF coverage) and 4.1x stress sensitivity (leverage). Use the four metrics together—don't rely on yield alone.

Dividend Sustainability Checks