Keeping Our Bearings with Quality Grades

Even the highest-quality names will take a hit in a crisis, but they’ll recover more quickly when the dust clears. And you’ll collect a rising stream of dividends in the meantime.

Utilities and other essential-service companies’ revenue holds up better during economic downturns because customers will dig deeper to keep their lights, water and phones on. But not all essential-service companies are equal, a point underscored by our proprietary Quality Grades.

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This system rates business strength of the more than 200 companies covered in our Utility Report Card on the familiar academic scale of A (best) to F (worst).

Although many companies have earned the same Quality Grade since the publication’s inception, others receive upgrades or downgrades depending on recent developments. We also do a mass refresh of our Quality Grades after every earnings season.

We incorporate five criteria into our Quality Grades: dividend sustainability, revenue reliability, regulatory relations, balance sheet strength, and operating efficiency.

Dividend Sustainability

When I first started covering utility stocks in the late 1980s, I focused on payout ratios as the primary measure of dividend safety. Over the years, experience has taught me that the more important question is whether a company’s underlying business can support dividend growth for the coming year and thereafter.

The payout ratio merely provides a snapshot of a company’s health over a particular three-month reporting period. Any number of developments can influence that coverage in future quarters, even for a regulated utility with a history of stable revenue. A dividend can look safe in one quarter and endangered only three months later.

The potential for errors increases when investors consider the wrong measure of profitability to calculate dividend coverage—for example, by including one-time or non-cash items. That’s why I calculate every payout ratio in the Utility Report Card individually.

However, this metric represents just one data point that helps us to grade the sustainability of a company’s dividend.