7 Reasons to Sell a Dividend Stock

Most investors spend a lot of time figuring out when to buy dividend stocks. This makes sense, as buying at the right price gives you room for profit while securing your dividend income. But knowing when to sell dividend stocks is just as important for your long-term success.

As a dividend investor, your main goal is to build a portfolio of stocks that provide consistent income through dividends. You want companies that regularly pay dividends, show strong dividend growth, and offer good dividend yields. This strategy lets you benefit from compound growth, where both rising dividends and increasing stock prices work together to build your wealth.

However, certain situations may threaten this system. When that happens, you should consider selling the dividend stock causing the problem. This post focuses on explaining when selling a dividend stock makes sense and how to recognize these important warning signs.

Reason #1: Lack of Dividend Increases

If a company hasn't increased its dividend for a year or two (outside of a major market recession), this is often a warning sign. As dividend investors, we need both dividend yield and dividend growth to maximize the compound effect.

When a company stops raising its dividend, it usually signals cash flow problems or high debt levels. This situation can eventually lead to dividend cuts or suspensions.

Johnson & Johnson Example

Johnson & Johnson (JNJ), a mega blue-chip company that operates in the consumer, pharmaceutical, and medical devices industry, has increased its dividend for over 60 years, even during recessions.

Here's a chart of their dividend payments since 1995:

This consistent pattern of dividend growth suggests reliable cash flow and disciplined capital allocation.

AT&T Example

In contrast, AT&T (T), a telecommunications and media conglomerate, paints a different picture.

AT&T had a strong history of growing its dividend consistently for 25 consecutive years, earning it "dividend aristocrat" status. However, in 2022, the company lowered its dividend after spinning off its WarnerMedia business and hasn't raised it since. This reduction came as AT&T needed to address its high debt levels and reallocate capital.

Here's a chart of their dividend payments since 2006:

Even established dividend aristocrats can change course when business conditions demand it. For dividend growth investors, AT&T's break in its 25-year streak signaled a fundamental shift that couldn't be ignored.

Reason #2: Dividend Cut or Suspension

If a company cuts or suspends its dividend, this is (usually) a clear signal to sell immediately. Without dividends, there's no compound growth, which ruins the entire dividend investment strategy.

Dividend cuts may indicate serious problems:

• Cash shortages
• Poor management
• Unsustainable debt levels
• Bankruptcy risk
• Failing business model

These cuts happen more often during recessions when companies may generate less profit. However, quality dividend stocks will maintain or even grow their dividends during tough times.

Therefore, we should look for companies that have historically sustained or increased their dividends during economic downturns, as this demonstrates financial strength and management's commitment to shareholders.

Abercrombie & Fitch Co. Example

Abercrombie & Fitch Co. (ANF) generates revenue through selling apparel, personal care, and accessories to the general public.

ANF paid consistent dividends from 2004 until March 2020, when the company completely cut its dividend. Not only had ANF failed to grow its dividend since 2013, but the elimination of payments came as store closures and declining free cash flows made the dividend unsustainable.

Here's a chart of their dividend payments since 2004:

While the decision to preserve cash during a crisis shows responsible management, it doesn't matter for dividend investors who require both steady payments and growth. Thus, when news of Abercrombie's dividend cut was announced, investors focused on dividend income should have sold their positions.

Dividend Coverage Ratio

A useful metric to help identify potential dividend cuts is the dividend coverage ratio (DCR). The DCR shows how many times a company can pay its current dividend using its earnings:

Dividend Coverage Ratio (DCR) = Earnings Per Share (EPS) / Dividend Per Share (DPS)

This ratio helps determine if a dividend is sustainable:

• < 1: The company pays more in dividends than it earns (very risky).
• 1: The company pays 100% of earnings as dividends (unsustainable).
• 1-1.5: Classified as unsafe, likely facing a future dividend cut.
• 1.5-2: Probably a safe dividend with healthy earnings.
• > 2: Very safe and healthy ratio, ideal for dividend investors.

A company with a ratio above 1.5 is likely allocating enough earnings to shareholders while maintaining sufficient funds to reinvest in the business and remain competitive.

If we examine the dividend coverage ratios from 2019 for JNJ and ANF, we can see how this metric signaled ANF's subsequent dividend cut:

JNJ's DCR of 1.53 placed it just within the "safe" category, suggesting its dividend was sustainable. Meanwhile, ANF's 1.39 ratio fell into the "unsafe" zone, providing a warning sign to investors months before the company actually eliminated its dividend in March 2020.

Reason #3: Significant Changes in Dividend Payout Ratio

The dividend payout ratio (DPR) shows what percentage of a company's earnings goes toward paying dividends. A sudden increase or decrease (~10% or more) in this ratio can be concerning.

A sharp increase doesn't necessarily mean better dividends. It often means the company isn't generating enough profit but is trying to keep shareholders happy.

Alternatively, companies might drastically reduce their payout ratio to preserve cash or buyback stock, which can actually benefit shareholders in the long run through increased share value.

The DPR formula is shown below:

Dividend Payout Ratio (DPR) = Dividend Per Share (DPS) / Earnings Per Share (EPS)

Note: The DPR is the mathematical inverse of the dividend coverage ratio (DCR) discussed earlier. While DCR shows how many times earnings cover the dividend, DPR shows what percentage of earnings are being paid out as dividends.

The ideal payout ratio varies by industry. Companies in industries with more stable earnings (e.g., utilities and consumer staples) can maintain higher ratios than companies in industries with cyclical earnings (e.g., technology or consumer discretionary).

When analyzing this ratio, try to understand why it changed. Significant increases in the payout ratio often precede dividend stagnation or even dividend cuts. Ultimately, if a company is paying out too much of its earnings as dividends, it has less money to invest in growth or handle downturns, making future dividend increases unlikely and cuts more probable.

Reason #4: Credit Rating Downgrades

Financial rating agencies like Standard & Poor's, Moody's, and Fitch evaluate companies and assign credit ratings based on financial strength. These ratings specifically assess a company's ability to repay its debts and indicate the level of risk for bondholders and lenders.

When a company's credit rating gets downgraded, it faces higher borrowing costs. This can lead to dividend suspensions as companies try to preserve cash flow and prevent further downgrades.

In these cases, you should always review the rating agency's explanation for the downgrade.

Additionally, check the company's financial statements, particularly debt-to-equity ratios, interest coverage ratios, and free cash flow trends. Then, assess whether these financial issues might impact dividend sustainability. If the financial outlook threatens the company's ability to maintain its dividend, consider selling your position.

Exxon Mobil Example

Exxon Mobil (XOM), a multinational oil and gas dividend-paying energy company, experienced credit rating downgrades from Moody's—first to Aa1 in April 2020, and then to Aa2 in March 2021:

While these ratings still represent high investment-grade quality, the downgrades signaled concerns about Exxon's cash flow generation, debt levels, and financial strategy during a challenging period for energy companies.

Note: You must sign up for Moody's (for free) to view detailed information and to search for other credit ratings.

Reason #5: Elimination of Stock Buybacks

Companies with strong cash reserves often buy back their own shares. This reduces the number of shares available to the public, which can make remaining shares more valuable over time.

This practice is especially prevalent in low interest rate environments, where companies can issue cheap corporate debt to fund buybacks, effectively replacing equity with less expensive debt capital.

Related: Importance of Stock Buybacks for Investors

When a dividend-paying company suspends its stock buyback program, it may indicate cash flow problems or excessive debt. If a company can't support its buyback program, a dividend cut might follow, as both activities rely on excess cash flow.

You can track stock buybacks by reviewing company announcements or checking quarterly financial statements to see if the number of outstanding shares has decreased. A consistent reduction in shares outstanding typically indicates an active buyback program, while an increase might signal dilution or financial stress.

Reason #6: High Dividend Yield and Falling Stock Prices

When evaluating dividend stocks, investors should be cautious of unusually high yields, especially those that result from falling share prices rather than dividend increases. Unlike companies in sectors like REITs or utilities where higher yields (i.e., ~5-7%) are normal due to their business models, an unusually high yield in other sectors often serves as a warning sign.

The relationship between stock price and dividend yield is inverse. As a stock's price falls, its dividend yield automatically rises if the dividend payment stays the same:

Dividend Yield = Dividend Per Share / Share Price

For example, if a stock pays $1 in annual dividends and trades at $25, its yield is 4% ($1 / $25). If the stock price drops to $12.50 while the dividend remains at $1, the yield doubles to 8% ($1 / $12.50).

When a company's share price declines significantly while its dividend remains unchanged, this often reflects market concerns about the company's future. Companies with falling stock prices that maintain high dividends may be:

• Cutting necessary operational or growth investments.
• Misallocating cash that should go toward debt reduction.
• Taking on additional debt specifically to fund dividends.
• Issuing new shares at depressed prices, diluting existing shareholders.

These unsustainable practices eventually lead to financial distress and, ultimately, dividend cuts. By monitoring for this pattern of falling stock price combined with an unusually high yield, investors can often identify dividend problems before the actual reduction is announced.

Reason #7: Drastic Stock Price Increases

Many dividend investors overlook sudden jumps in a company's stock price as a potential selling opportunity. While normal daily fluctuations and movements that follow the broader market aren't cause for action, watch for sudden stock price increases (e.g., ~10%) within a short period of time.

When this happens, consider selling a portion of your holdings in that company. Selling around 10-20% of your position can be a sensible approach that balances capturing gains while maintaining your core investment.

Stock prices that rise rapidly sometimes experience corrections afterward, though this isn't guaranteed. Regardless, by selling a portion during the spike, you create flexibility with your newly available capital.

It's important to keep your emotions in check during these situations. Even if the stock continues trading at the higher level, you haven't really lost anything. You've captured some profits and still maintain most of your original position with unrealized gains.

You have two good options for these proceeds:

1. Buy back shares of the same company if the price returns to previous levels.
2. Reinvest in other dividend-paying stocks with attractive valuations.

In either case, your overall portfolio return should improve.

As your dividend portfolio grows over time, you'll likely encounter this pattern more frequently. Make it a habit to monitor unusual price movements across all your holdings. Even the most stable dividend stocks experience price fluctuations, so watch for these potential opportunities.

The Bottom Line

While there are several reasons that might suggest it's time to sell a dividend stock, it ultimately comes down to whether the company is managing itself effectively and using its cash wisely.

Large, established dividend-paying companies with strong management usually have manageable debt levels and use cash effectively. These businesses are often so dominant and diversified that they have room to grow and continue paying dividends.

However, with smaller dividend-paying companies or those in more volatile industries, you should monitor these warning signs carefully to protect your investment and income.