Beware of dangerously high dividends
A high dividend yield can signify an undervalued stock and be an important component of the return an investor earns...
But it can also be the sign of a value trap – in particular, if the company isn't generating enough free cash flow ("FCF") to sustain the dividend and is forced to cut it.
Today, I'd like to share my analysis of the cash-flow statements of four companies to illuminate examples of both...
1) I first wrote about pharma giant Pfizer (PFE) on October 8, which is paying out $9.5 billion in dividends annually – giving it a yield of about 6.6%.
In that e-mail, I showed this chart of Pfizer's capital allocation – which includes a steady and rising dividend (the only cut was during the global financial crisis) as well as periodic share repurchases and big acquisitions:
At that time, I was scared off by the crash in the company's FCF, which had fallen to around $5 billion annually. Here's the chart of cash from operations, capital expenditures ("capex"), and FCF that I showed:
However, as I showed in last Wednesday's e-mail when I broke down Pfizer's FCF by quarter and included the two quarters since my October 8 e-mail, the picture brightens considerably:
Pfizer has generated a combined FCF of about $12 billion in the past two quarters, which makes me think its current dividend is safe.
That doesn't mean the stock is a buy... but it's unlikely to crash because of a dividend cut.
2) In yesterday's e-mail, I wrote about shipping giant United Parcel Service (UPS), which pays a nearly 6% dividend (equal to about $1.35 billion per quarter), as this chart shows:
Is that sustainable? Yes, but not with a lot of room to spare...
UPS's trailing-12-month dividend payouts were $5.4 billion, which is 87% of the roughly $6.2 billion of FCF the company generated. Here's the breakdown by quarter of cash from operations, capex, and FCF:
It's also important to look at the balance sheet to see if a company could borrow to maintain its dividend if FCF falls.
In UPS's case, the answer is a definite yes, as it only has roughly $19 billion of net debt – a small fraction of its $93 billion market cap and equal to only about 1.8 times its trailing-12-month earnings before interest, taxes, depreciation, and amortization ("EBITDA").
UPS could easily borrow twice its current debt load, which would cover multiple years of dividend payments.
3) At the opposite extreme, it would be hard to find a better example of terrible capital allocation and what happens when a company is forced to cut its dividend than Stellantis (STLA) – the maker of Chrysler, Dodge, Jeep, Fiat, and many other auto brands.
Look at what the stock has done over the past year – at yesterday's close of $12.40 per share, it's down by 58% from a year ago:
This was quite predictable to anyone paying attention to the company's cash-flow statement, as FCF fell off a cliff in mid-2023 and was negative for every quarter in 2024:
But Stellantis kept paying out big dividends all through last year and, even more crazily, kept buying back stock:
When the company reported earnings on February 26, it said it was cutting its dividend by 56% this year – but is still yielding close to 6%.
What a mess – avoid this stock.
4) Lastly, let's look at another automaker, Ford Motor (F), which is yielding about 5.8%. Ford has paid out around $0.15 a share, or $600 million, per quarter ($2.4 billion annually) for most of the past decade, as you can see here:
Is Ford generating enough FCF to cover a $2.4 billion annual dividend payout? Absolutely yes, based on historical numbers. As you can see in the chart below, it generated about $6.7 billion of FCF last year:
But of course, investors are forward-looking...
As such, they're questioning whether the impact of tariffs could force Ford to slash its dividend – as this recent Wall Street Journal article notes: Ford's Fat Dividend Could Be a Casualty of Tariffs. Excerpt:
Ford has said President Trump's new import tariffs, if sustained, would cause its earnings to tumble. A dividend cut would appear likely, based on Ford's latest profitability guidance. If Trump expands tariffs beyond what has taken effect already, the payout reduction could be much greater than the market is expecting...
Ford also spent $426 million last year on share repurchases. Combine those with the dividend payments, and the $3.5 billion in shareholder distributions were equivalent to the low end of this year's guidance for free cash flow. As things stand, the trajectory for Ford's capital returns this year is headed lower.
Ford says it targets shareholder distributions, including dividends and buybacks, of 40% to 50% of its free cash flow. Thus even the high end of its guidance signals a dividend cut. How big that will be hinges greatly on how hard any tariffs will hit. Ford has paid about $1.2 billion of dividends this year so far, including the supplemental payout. Its 2025 guidance implies $1.4 billion to $2.25 billion of dividends and share buybacks, combined.
My best guess (and it's only a guess) is that President Trump, above perhaps any other industry, doesn't want to hurt the automakers – they employ nearly 10 million Americans, or roughly 5% of the private-sector workforce. So he'll make tariff exceptions for them – meaning Ford's FCF wouldn't be hurt too badly and its dividend would be safe.
Again, however, that doesn't mean its stock is a buy. Like with airlines, I don't like the automaker business... which is why I tend to avoid these companies' stocks.
Best regards,
Whitney
P.S. I welcome your feedback – send me an e-mail by clicking here.