Building A Strong Retirement Income Portfolio - Part 3: Dividend Coverage And Valuations (2024)

In parts 1 and 2 of this series, we offered you an overview of many classes of high-yield income vehicles, where to find them, and trading tips for certain high-yield vehicles. We also discussed risk management, diversification, mental attitude, market sentiment, cash level management, and assembling a watchlist.

Part 3 will focus on dividend coverage, i.e., how to tell if an income vehicle is covering its dividends/distributions or not. We'll also discuss valuations for high-yield asset classes, including a table which details comparative valuation metrics used for assessing a potential investment.

Dividend Coverage:

First of all, you need to know that, like valuations, dividend coverage is a moving target, which can vary from quarter to quarter. A good idea is to check the company's website and also check Seeking Alpha's dividend pages to assess the strength of an income vehicle's dividend coverage.

One technical note: The terms dividends and distributions are sometimes used interchangeably. In general, when a company pays shareholders money, it's a distribution of either dividends or return of capital, or a combination of both. Sometimes it can also be a distribution of capital gains.

Dividend payouts can be measured in two basic ways:

1. The Dividend Payout Ratio, which divides either the dividends/share for the most recent four quarters by the Earnings per Share, or divides the total dividends paid by earnings/net income for the same period.

There are variations on this for REIT's, which use Funds From Operations, and/or Adjusted Funds From Operations, and/or Funds Available For Distribution, instead of Net Income/Earnings, as the basis for their payout ratios.

2. Dividend Coverage Factor. This is just the inverse of a dividend payout ratio. LPs tend to use the dividend coverage metric, while REITs and Corp.s will use a dividend payout ratio, based upon their respective earnings/cash flow metrics.

One pet peeve of ours, is when a company's earnings release uses a bunch of acronyms, with no explanation of their meanings. This seems to be happening more frequently. Maybe the CFOs are filing the earnings releases on their cell phones, and their thumbs are getting too tired to spell things out, at least once?!!

Anyhow, this table includes some of the distribution coverage metrics and their acronyms that you'll come across on your quest for competitive yields.

Common stocks tend to measure their dividend payout ratios by Earnings Per Share, and, more and more by Free Cash Flow.

Preferred stocks' payout ratios vary by the type of entity that issues them. They aren't often listed on company's earnings releases, but you can figure them out pretty quickly, providing the company breaks out its preferred dividends paid amount.

Since Preferred dividends are usually deducted before Net Income is determined, just add the amount of preferred dividends back to net income, and then:

1. Divide that total, $12,000.00 in the example below, by the amount of preferred dividends paid during the same period, $2,000.00 in the example.

The Preferred Dividend Coverage factor in the example is 6, which you'll often see expressed with an X after it, such as 6X.

2. For the Preferred Dividend Payout Ratio, just divide the Preferred dividends paid, $2,000.00, by the Net Income + Preferred Dividends paid, $12,000. The payout ratio in the example is 16.67%.

TIP: If you can't find the preferred dividends paid total on the income statement, look for it in the company's Cash Flow statement, in the Cash Flows From Financing Activities section.

Limited Partnerships, or LPs, tend to use Distributable Cash Flow, DCF, as their Distribution Coverage metric. You can also use DCF to measure their Preferred Distribution Coverage.

Here's an example of this for CNX Midstream Partners LP (CNXM). CNXM's quarterly distribution/unit increased in each of the last four quarters, while its distribution coverage factor averaged 1.48X, which is a very strong coverage factor for a midstream pipeline company.

You can use the LP's reported distribution coverage factor, which is usually discussed on quarterly earnings releases, in tandem with its quarterly distribution/unit, to determine its trailing distribution coverage factor over the past four quarters.

We also use it to generate Distributable Cash Flow/Unit, which comes in handy when comparing an LP's valuations to its peers. (There's more on this in the Valuations section.)

Coverage factors can be lumpy sometimes, due to quarterly timing issues, so, it's a good idea to keep track of the trailing coverage factor.

REITs: As noted earlier, REITs base their payout ratios on Funds From Operations, FFO, and/or Adjusted Funds From Operations, AFFO, and/or Funds Available For Distribution, FAD.

Here's an example of an FFO Distribution Payout Ratio for Industrial Logistics Properties Trust (ILPT), a REIT which we hold in our Hidden Dividend Stocks Plus service.

We consider ILPT to be an attractive high-yield back door to Amazon (AMZN) and e-commerce, as AMZN is its biggest tenant.

ILPT generated quarterly FFO/share in a mostly upward range of $.40 to $.46 over the most recent four quarters, while holding its quarterly payout steady at $.33/share. This resulted in a better (lower) dividend payout ratio in Q2-Q3, which ranged from 71.74% to 75%, respectively, vs. the 82.50% to 80.49% payout ratios ILPT had in Q1 '19 and Q4 '18.

In general, just like EPS, you want to see FFO or AFFO growing, or at least steady, while the REIT's payout ratio is trending down or stable. Although REITs are required to pay out 90% of earnings to shareholders, the closer to 100% the FFO or AFFO payout ratio is, the poorer the payout ratio is, so if it's stable, it shouldn't be up around or above 100% for four quarters or more. If it is, your REIT may possibly be headed for a distribution cut in the future.

Mutual Funds: This brief table lists some of the many types of mutual funds available to retail investors - it's a vast sub-industry.

CEF's and mutual funds are required to pay 90% or more of net investment income from dividends and interest payments, and 98% or more of net realized capital gains.

The trick is to find CEF's which aren't on an unsustainable dividend path. When this happens, Return of Capital can be part of the distribution, which can be destructive the fund's Net Asset Value. Return of Capital from any entity is tax deferred, until you sell. Although the tax sheltering can be useful, just be aware that Return of Capital decreases your tax basis, which increases your taxable profit, if you eventually sell. Of course, if you plan on living forever and never selling, or, if you really don't like your heirs, well, that's another story.

The statements from CEFs can sometimes be confusing - you'll find the total and Net Investment Income, NII, in the Statement of Operations, but the realized capital gains are often listed in another section - Realized and Unrealized Gains/Loss on Investments. For purposes of comparing the CEF's total earnings to its distributions, the unrealized gains are non-cash, and shouldn't be counted. The total NII and realized Capital Gains will give you the amount of $ the fund generated.

Valuations:

This table gives you the typical metrics used in valuing these various income vehicles. Price/Earnings per Share, or P/E, is probably the most widely known, as it has been around for ages.

There's an interesting extension of P/E, called PEG, which compares a company's current or forward P/E to analysts' EPS growth forecasts for this year, or the next year, or in some extremely "optimistic" cases, even further out in time. A PEG value below 1 is generally considered as a sign that a stock may be undervalued.

Price/Free Cash Flow, P/FCF, also is a very popular valuation metric, particularly when looking at cash cows - these stocks may not have fabulous growth, but they generate large amounts of free cash flow, which gives them the opportunity to reward shareholders with growing dividends and/or share buybacks.

Preferred stocks usually have a call value of $25, $50, $100, or $1,000. If you're comparing two similar preferreds, one thing to look at is how far or above their call values each stock is. Playing into that is, as always, their yields, but also how close they are to their call dates. If one stock is priced at $26.00, with a $25.00 call value, and pays $.50/share per quarter, that means you'll need two quarterly payouts before you get back to a $25.00 breakeven. But what if its call date is before the second quarterly payout? That's something to consider.

This preferred stock, the Cincinatti Bell 6 3/4% B shares (CBB.PB), currently yields 9.43%, because it got beaten up, along with the common shares, and is currently at $35.81, far below their $50.00 call value.

However, looking at CBB's free cash flow, FCF, shows a FCF/Preferred Coverage factor of 2.33X for Q1-Q3 '19:

This is an atypical "walk on the wild side" type of preferred scenario from those that we usually cover, but some of its characteristics illustrate the concepts we're trying to convey.

These shares are long past their call date, which was back in year 2000.

However, let's imagine that they're going to be called in one year, on 12/19/2020. This gives us four quarterly $.8438 dividends left to collect, for a total of $3.38.

Then, we look at the call value - there's a $14.19/share spread between the current price/share of $35.81 and the $50.00 call value. That $14.19 plus the $3.38 would give us a total profit of $17.57, if these shares were magically called on 12/19/2020, at their $50.00 call value.

It used to be that preferreds often had Maturity Dates, a future date at which the issuing company would redeem them. However, that's a less frequent occurrence these days. In fact, due to the about-face that the Fed did on raising interest rates in 2019, most preferreds have risen above their call values, after bottoming out in Q4 '18. But, be patient, maybe they'll start raising rates again some day, and we might pick up some more bargains.

Hybrid preferreds are a bit trickier to assess. You have to compare their future floating rate, which is usually based upon the three-month LIBOR rate, to their current yield, at various three-month LIBOR rates, to see how their future equivalent yield at today's price compares to their current yield.

Tip: Look for a higher floating rate, which will give you more cushion against lower future LIBOR rates.

For LPs we look at Price/Distributable Cash Flow per share, or P/DCF, and compare to an LP's peers, whether in the midstream pipeline or the LNG shipping space.

Here's another look at CNXM, with comparative valuations for other high yield midstream LPs which we follow.

In addition to showing a higher yield, CNXM's current Price/DCF of 6.77 looks a lot cheaper than the average of 7.95. Its Distribution Coverage factor of 1.48 is also better than the 1.34 average.

Its Price/Book is ~average, at 2.62 vs. 2.67, while its EV/EBITDA, a valuation which takes in both equity and debt capitalization, is much cheaper, at 7.19, vs, 8.91. Overall, CNXM looks like it's undervalued, based on most of these metrics. Of course, part of that is due to negative market sentiment toward energy stocks.

CEFs are valued on their Net Asset Value, P/NAV, often with considerable discounts. However, always take a look at their historic premium/discount to NAV valuations to see if their current discount is as deep as it may have been over the past year, three-year and five-year period.

Another way to compare CEF's current valuations is by their Z scores, a measure of standard deviations from the mean. You also should look at historic Return on NAV, expense ratios, and whether their distributions are fully funded or just Return of Capital, and, of course, always compare yields.

There are many ways to compare Mutual Funds - fees (loads), yield, expense ratios, performance vs. benchmark index, how long a fund manager has been with the fund, sector risk, interest rate risk, and more. A quick resource for measurement is Morningstar, which has very broad and deep coverage of mutual funds.

Bond investors use, among other tools, a present value calculation to assess the current value of a bond. In addition, there are the ratings from the various rating agencies, such as Moody's, which, hopefully, are doing a better job currently than they did during the housing crisis.

Closing Thoughts:

We hope we've given you some useful tools and resources to aid you in your long journey toward building a strong retirement portfolio. We'll be covering additional comparative metrics and examples in our next article in this series.

All tables furnished by DoubleDividendStocks.com, unless otherwise noted.