Is This Thing Safe?

January 21, 2013 Is This Thing Safe? Marc Lichtenfeld, Investment Director, Wealthy Retirement   Most Recent Articles   You Cannot Afford to Miss This Opportunity Three Reasons Why You're Better Off Alone Where High Yields Can Hide Real Problems   In the News   A Strategy That Works No Matter Who's in Washington Is Your Dividend Safe? Would An Increase in Tax Rate Hurt Dividend Stock Investing?   Two-Minute Retirement Solutions   I recently closed on a real estate loan. When I saw the funds hit my account, there was a sinking feeling in my stomach. The amount was less than I expected. It turns out there was a clerical error and it all got straightened out. But anyone who has expected a certain amount of money - whether from a loan, an asset sale, a bonus, etc. - knows the feeling I experienced. But those examples are all one-time payments. For dividend investors who expect a set amount of quarterly income, a dividend cut can be even more painful, and its effect could last even longer. That is why you should always check the company's payout ratio before investing in any dividend payer. The payout ratio is a simple equation that helps determine if a dividend is safe. To calculate it, take the dividends paid (found on the cash flow statement) and divide the figure by the company's net income (found on the cash flow statement or the income statement). For example, drugmaker Eli Lilly (NYSE: LLY) currently has a 3.7% yield. Over the past 12 months, it paid out $2.2 billion in dividends, while earning $4.1 billion. To find the company's payout ratio, divide 2.2 billion into 4.1 billion and we get a figure of 54%. Typically, I want to see a payout ratio of 75% or less. That tells me that even if net income falls, the company will still be able to pay (and hopefully raise) the dividend. What About My MLP? Master Limited Partnerships (MLPs) are different. Because they don't pay corporate income tax, MLPs must pay out 90% of their profits to unitholders. (Owners of MLPs are called unitholders not shareholders.) But many MLPs routinely pay out more cash than they earn. For example, in its fiscal third quarter, Plains All American Pipeline (NYSE: PAA) earned $0.27 per unit in profit, but declared a quarterly distribution (MLPs pay distributions not dividends) of $0.5425 - double what the company earned. Clearly, that's not sustainable, right? Wrong! When examining an MLP, rather than being concerned with earnings, look at distributable cash flow (DCF). That's how much cash the company generated that's available to be distributed to unitholders. In Plains All American's case, there were $360 million in DCF and 331 million units outstanding. Divide those two figures and you get $1.08 - twice what the company sent unitholders last quarter. So although the company earned only half of what it paid out, the amount of cash it generated was double what it sent to unitholders. That's why when measuring the health of an MLP's payout, we should always use DCF instead of earnings. Cash is King In fact, even when looking at traditional companies, I like to use cash flow rather than net income. Cash flow measures how much cash came into the business. Earnings have all kinds of non-cash items in the calculation, like depreciation and stock-based compensation. While many folks on Wall Street use profits to value a business, cash flow is what an investor must use to determine if a dividend is safe. So if you own an MLP, don't sweat if it pays out 100% or more of its profits. It doesn't matter one bit. As long as it's paying less than 75% of distributable cash flow, you're in good shape. Companies that are below that key 75% level should be able to continue to pay and raise their dividend - even if the company has a bad year or two. Get above that threshold, though, and the company doesn't have much padding during down years - a surprise bad quarter or two could lead to a painful dividend cut. By analyzing your MLP's payout ratio using distributable cash flow, you should never have that sickening feeling of opening an envelope to discover there are less zeroes on your check than you expected. Click here to post a comment on WealthyRetirement.com. © 2013 Wealthy Retirement. All Rights Reserved. 105 West Monument Street Baltimore, MD 21201 North America: 1.800.992.0205; Fax: 1.410.223.2650 International: +1.410.223.2643; Fax: +1 410 223 2650 E-mail: WealthyRetirement@WealthyRetirement.com Website: www.wealthyretirement.com You are receiving this email because you subscribed to Wealthy Retirement. To unsubscribe from Wealthy Retirement, click here. To cancel by mail or for any other subscription issues, write us at: Wealthy Retirement Attn: Member Services 105 West Monument Street Baltimore, MD 21201 Keep the e-mails you value from falling into your spam folder. Whitelist Wealthy Retirement.