Using the 5 Cs of Credit to Evaluate Dividend-Paying Stocks
C1 — Character: Is the borrower willing to repay the loan?
Applying this to a dividend paying stock, we will examine the dividend payment track record and the existence (or absence) of a dividend policy to determine the “willingness” of a company to pay dividends. Unlike interest payment on a loan, dividends are non-mandatory and entirely at the discretion of the company. A long-term dividend-paying track record is the best indicator of "willingness" of a company to pay dividends.
C2 — Cash flow: Does the borrower have sufficient cash flow to service the interest and principal payments on the loan?
Coverage ratios such as EBIT/Interest, EBITDA/Interest or FCF/Interest should far exceed one, implying that earnings and/or cash flow are sufficient to meet interest obligations.
C3 — Capital: What assets or capital does the borrower have?
C4 — Collateral or security: Can the borrower put up security or get individuals or corporates to
guarantee the repayment of the loan?
Companies can sell their assets to repay the debt owed to creditors in the worst case. Companies with valuable assets that can be easily sold have greater credit strength. In the case of REITs, they own income-producing properties.
In addition to the quantity of assets, the quality of assets should be considered. Cash and prime location real estate are more valuable than obsolete plant and equipment and non-salable inventories.
C5 – Conditions: How much have the company’s sales and net margins fallen by relative to the industry in the past economic recessions? How has the company’s share price performed relative to the market in past bear markets?
We have to envisage a worst-case scenario for the companies. For the non-REIT dividend-paying stocks, they are typically companies in stable non-cyclical industries that are not as severely affected by economic downturns. For REITs, the defensiveness of the underlying property sub-sector should be examined. For example, sub-urban retail rents have historically shown greater resilience compared with prime office rents.
If a bank does not want to lend money to your dividend stock, you should forget about "lending money" to them (investing in the stock).