stocks with weak revenue EPS and dividend growth: interpreting the dividend triangle Archives

Worried about holdings that show a weak dividend triangle? Revenue and EPS are falling, dividend growth is slowing down, or worse absent. What do you do? Last week we explored how to analyze falling revenue in a weak dividend triangle. Now we look at interpreting weak EPS and dividend growth.

In last week’s article, we explained the importance of putting metrics fluctuations in context and that the trend is your friend, meaning you must look at the evolution of metrics over time to understand what’s going on. Missed it? Read it here.

When earnings per share (EPS) are down

Earnings going down means the company is making less profit, not something that you like to see. Again, however, you must put that in context.

First, understand where that number comes from. EPS is based on accounting principles. Consequently, major events like impairments, one-time charges for an expansion and acquisition, and amortization impact the EPS even though these events aren’t necessarily bad things. Seeing the EPS go down raises a flag regardless, and it must be investigated. Reviewing the trend in Adjusted EPS (also called non-GAAP) can help here because one-time charges and amortization are not included.

Companies that make a lot of investments in assets or infrastructure have a lot of amortizations, and their EPS fluctuation often causes confusion.

Example: Brookfield Corporation (BN.TO / BN)

Recently, at the same time Brookfield Corporation (BN)’s EPS was going down, it announced a generous dividend increase. A business whose profit is plummeting is raising its dividend. “I’m losing my job I think I’ll buy a car.” It doesn’t make sense.

Since BN makes a lot of investments, it’s better off to look at funds from operation (FFO) and FFO/share rather than EPS. The FFO/share is at homemade metric and is not always easy to find. Financial websites show the adjusted EPS or EPS; digging into the quarterly statements and investor presentations will give you the correct picture. For Brookfield, they showed a company that’s growing and thriving, but EPS isn’t showing that profit yet.

Find stocks with a strong dividend triangle from our Rock Stars list, updated monthly!

Example: TD Bank (TD.TO /TD)

Another example from last year was TD Bank which had lots of one-time fees in its financial statements.

Fees for TD’s decision to abort the acquisition of First Horizon, a prudent move in light of many U.S. regional banks having problems with their balance sheets, and some of them going bankrupt in 2023.
The FDIC, which ensures deposits in the US, requested a special assessment of all banks in the U.S. As TD does a lot of business there, it spent $100M for FDIC assessment, passing the stress test and proving it’s well capitalized and has a robust balance sheet
Due to the economy, all banks had to raise their provisions for credit losses.

Combining these three unrelated factors hurt the EPS, whose trend doesn’t look sharp right now.

Graph of TD's dividend triangle that shows weakening EPS but steady dividend growth — TD EPS fell, but dividend growth is still there

Yet TD kept increasing its dividend last year and will continue in 2024 why? While the one-time events hurt the business, going forward, we’ll forget all about those as the business will thrive.

What about dividend growth slowing down?

Slowing dividend growth is usually the result of the rest of the dividend triangle; it’s rare to see a company with a high single-digit to double-digit growth for revenue and earnings whose dividend growth is slowing down.

If you see a dividend increase slowing to 3% and then 1% after being at 6% over 3-4 years, chances are both revenue and earnings were slowing down before that. It is prudent management to slow dividend growth rather than bleeding a balance sheet to death just to pay shareholders, but it’s also a red flag.

Find stocks with a strong dividend triangle from our Rock Stars list, updated monthly!

Can the payout ratio help to assess dividend growth health?

Yes, definitely. When the dividend triangle is weakening and the dividend growth is slowing down, the payout ratio is probably rising. Now we’re looking at the Sell button on our dashboard. However, it’s important to look at the appropriate payout ratio. There’s the classic payout ratio based on earnings. As I said earlier, earnings are based on accounting principles, not on cash flow. You should be mindful of that.

The cash payout ratio is an interesting metric. It’s based on free cash flow, so it does not consider the company taking on more debt to finance capital expenditures. For a capital-intensive business, the cash payout ratio is not perfect either. Instead, use the funds from operation FFO payout ratio. You could also simply compare the company’s dividend per share with the amount of Distributable Cash Flow (DCF) per share to see if there is room there for future dividend growth. See The Different Payout Ratios – A Quick Tour for more details about them.

Again, context is essential. That said, a weak dividend triangle and a payout ratio getting higher starts to scare me a bit more and bring me closer to selling, but I’ll do more research.

What other metrics can help understand a weak triangle?

When I’ve established that I’m concerned about a stock’s triangle, I start by looking at the cash from operations metric, because cash is closely linked to the ability to pay a dividend.

I also look at the long-term debt trend. If the debt keeps rising, and the payout ratio is above 100%, the company is leveraging its future; it better succeed in bringing profit and cash flow to the table and later because if not, it’s literally financing its dividend.

Growing debt can be understandable when there are large projects to fuel growth; the company is financing its projects and using its cash from operations to pay dividends. However, this situation cannot be sustained for a long time. It can last for a few years, but at some point, the company must stop adding debt and pay some of it down.

What’s next?

If after looking at these two sets of metrics (the three dividend triangle metrics, and the payout ratio and debt), I feel it might be fine to keep the stock, I do more qualitative research. The goal is to understand more about what’s wrong with the business model. Is it the economy hurting the business? Competitors? Can management resolve the problem? Has management said it was addressing the problem during the earnings conference call? If they just ignore the problem, that’s another source of concern.

For how many quarters should we tolerate a downtrend?

It’s not so much about a set number of quarters, but rather the reason why the metrics are slowing down. If it’s due to an economic cycle, like a recession that causes many companies in the consumer discretionary to have even two years of bad results or poor growth. Knowing that it’s normal in a recession, I would not sell after one year. However, if it’s because the business is losing market share and not finding ways to improve over several quarters, then it would be getting close to my sell list.

Do you have holdings showing a weak dividend triangle? Revenue or EPS is stagnating or falling, dividend growth is slowing down, or worse there is no dividend growth. Do you sell right away? Not so fast. First, interpret the weak dividend triangle to know what’s really happening and make the correct decision.

What’s the dividend triangle again?

The dividend triangle is a tool I’ve been working with for over ten years, successfully and it forms the basis of my investment process. The dividend triangle includes three metrics: revenue, earnings per share (EPS), and dividend.

The key to my investment strategy is to find companies that are capable of growing their revenue, either organically or by acquisition, but that constantly find ways to grow their sales. As investors, we want to invest in thriving companies. A company that found a way to grow its sales year after year is the first thing I look for.
Next on my list that, as an investor, I want to see in a company is more and more profit. Earnings per share track that. Every year, I want to see a company with more sales and higher earnings per share.
After finding this magical Unicorn—well, truthfully, many companies show strong revenue and earnings growth—the next factor I want is for the company to reward its shareholders with yearly dividend increases.

Get great stock ideas from our Rock Stars list, updated monthly!

Why these three metrics?

Since I focus mostly on dividend growers, I want to see constant and often increasing dividend growth. Good and constant revenue and EPS growth are preconditions to a growing and sustainable dividend. The combination of these three metrics often leads to companies that have positive cash flow, repetitive and predictable income, a robust balance sheet, and a business model that has plenty of growth vectors.

A company with a strong dividend triangle also comes with another bunch of great metrics. As an investor, that’s the type of business you want; a thriving business able to go through a recession without too many worries and that’ll honor its promise to increase its dividend year after year.

Learn more about the dividend triangle here.

What does a weak dividend triangle mean?

Look at Equinix’s dividend triangle. It’s easy to understand a positive dividend triangle, right? Revenue keeps growing as does the earnings per share. The dividend growth is steady and even increasing.

Three line graphs highlighting the strong dividend triangle for Equinix: trends of revenue growth, EPS growth, and dividend growth — Equinix (EQIX): a strong dividend triangle

How do we explain a weak one? What do we do when a good company’s dividend triangle is weakening? What if one metric goes down? After a bad quarter or even a few bad quarters, don’t instinctively click the Sell button. Just like our energy level and our weight, numbers fluctuate, it’s normal.

It’s all about interpreting these deteriorating numbers to see what’s happening and whether things will get better soon. As I like to say, the trend is your friend. You must look at the triangle metrics over time, 5 years is a good duration, to see whether the poor results are a hiccup or part of a downward trend over a long time.

Along with the trend, it’s important to put the results in context, i.e., understand what is going on with the company, or around the company, that is making one metric, or the entire triangle go down, or up for that matter. Monitoring your stocks every quarter will help you to quickly spot trends and put results in context.

Get great stock ideas from our Rock Stars list, updated monthly!

When revenue is going down

Whether revenue is fluctuating down or up, you can often find the context for the change in the quarterly results press release or the investors’ presentation. They usually explain the factors that affected the revenue positively and negatively. Revenue could be down for a pretty good reason in which case you shouldn’t worry too much. Here are some examples:

Currency fluctuation. Take Coca-Cola; it makes many sales outside of the U.S. and generates a lot of revenue in other currencies. Revenue reported in U.S. currency is affected by the exchange rate. A U.S. dollar getting stronger will affect its revenue downward. To see if there was revenue growth or not, it’s important to also look at the numbers on a currency-neutral basis, which is stated in the press release.
Cycle of innovation or product cycle. Look at Apple’s dividend triangle below. There’s no frenzy around iPhones, nor is the company launching many products. As a result, over the last five or six quarters, sales and earnings haven’t grown as fast as they used to. This is normal if you look at Apple’s history. It goes through product innovation cycles and occasionally there’s a pause in growth before starting another upcycle.

Three line graphs showing Apple's dividend triangle. Sales and EPS at a plateau for the last 2 years as per its innovation cycle — Apple’s sales and EPS reaching a plateau due to the company’s innovation cycle

Industry-wide cycle. We can think about basic materials and the energy sector for example. If you look at the 2015-2020 period versus 2021-2026, when we get there, we’ll have a completely different picture of the energy sector; the whole sector goes through cycles.
Sometimes it’s just the economy. Recent reports from Home Depot, Canadian Tire, and railroad companies reveal there are slowdowns. We cannot expect huge revenue or earnings per share growth for 2024, and possibly 2025. This isn’t limited to a specific company, but entire cyclical industries getting hit by consumers spending less.

Putting the revenue slowdown in context helps you to differentiate between a temporary cause, such as a cycle fluctuation or a negative currency impact, or a permanent situation. By permanent situation, I mean things that are specific to the company and not resolved by time alone, if at all. This could be a company losing market share as it cannot adapt to increased competition (think Blackberry), or a business that isn’t relevant anymore because it’s in a dying industry and fails to innovate or diversify; remember printed media and video stores?

What about falling EPS and slowing dividend growth?

Yes, the triangle isn’t just about revenue. EPS and dividends are also key metrics that can show signs of weakness. We’ll explore that in next week’s article, along with a few other metrics.

In the meantime, it’s important to understand that you must look at more than one metric to assess the state of a company’s performance, good or bad. Also, remember that putting things in context is a must and the trend is your friend!

Interpreting a Weak Dividend Triangle – Part 2