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A high dividend yield can be enticing, but it can also raise flags for income investors.
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Pfizer’s falling valuation has pushed its yield up to well over 7%, which warrants a closer look.
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The company’s payout ratio and free cash flow can help investors assess the safety of the dividend.
When a stock yields more than 5%, investors start to become skeptical about whether the payout is indeed safe. While it’s tempting to want to believe that it can be safe and that it can be an excellent source of future dividend income, you also don’t want to get burned and see that dividend get cut or suspended.
Consider pharmaceutical giant Pfizer (NYSE: PFE). Its dividend yield is around 7.5% right now, and if the stock continues to decline, it may not be long before it hits 8%. The big question is whether this is really a steal of a deal and a good buy, or if Pfizer may soon have to reduce its dividend?
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A good starting point for investors in analyzing a dividend stock is to look at its payout ratio. This considers the company’s dividend with respect to its earnings per share (EPS). The higher that EPS is in relation to the dividend per share, the lower the payout ratio, and the more sustainable the dividend is.
The company currently pays a quarterly dividend of $0.43, which totals $1.72 for a full year. And in 2024, Pfizer’s diluted EPS came in at just $1.41 — well below the rate of its annual dividend. However, this can be a bit misleading as the company incurred billions of dollars in restructuring expenses and asset impairment charges. These are non-cash items, but they can nonetheless impact the bottom line and make the company’s payout ratio look worse than it otherwise would be.
That’s why I say the payout ratio can be a good starting point when analyzing an income stock, but a high ratio doesn’t mean that investors should assume that the dividend is doomed. A better option may be to look at the company’s free cash flow.
Free cash flow tells investors how much cash a company is generating after deducting capital expenditures. It’s an important metric since it excludes the noise which often comes from non-cash items such as impairment charges and other non-recurring accounting adjustments.
Last year, Pfizer’s free cash flow totaled $9.8 billion, and its cash dividend payments came in at $9.5 billion. This suggests that the payout is indeed sustainable since Pfizer generated more free cash than what it paid out in dividends. There isn’t a huge buffer there, but there aren’t big red flags, either.