Looking Beyond Dividends

Foreword from ShareInvestor

This article “Looking Beyond Dividends” by Jason Low was first published in The Business Times on 26 May 2008 and is reproduced in this blog in its entirety.

The higher the payout ratio, the more likely it is the dividend may not be sustained. The lower the payout ratio, the greater the chance of the company sustaining or even increasing the dividends over time.

In this follow-up to last week’s introduction on dividends, Jason Low shares some tips on identifying good dividend-yield stocks

We said last week that yes, with high dividend-yielding stocks you might be able to obtain double rewards – dividend yield and capital gains. While knowing that a good dividend-paying stock can give your portfolio a boost, it is very necessary to dig deeper when picking high-yield stocks.

A company paying a low dividend of, say, 2 per cent may be a much safer bet than one that pays a high dividend yield of 10 per cent if the latter is in risk of cutting its dividends due to its inability to sustain them. Therefore, it is not sufficient to just blindly pick out the highest dividend-yielding counter from a stock screen.

In fact if one does that, one runs the risk of investing in a company that might not really be able to sustain the high dividends which could directly lead to a potential double whammy – a dividend cut and a subsequent stock price decline – instead of the expected bonus.

Rational shareholders would want the company to maintain its dividend and increase it over time. For this to happen, the company should have set aside sufficient cash to fund necessary capital expenditure. It should also set aside a level of cash buffer to maintain a margin of safety, while leaving some balance to pay out as dividends in increasing amounts overtime.

An increasing dividend can bring about a share price appreciation as the higher dividend yield makes a stock more attractive to investors than before. Take the case of Rickmers Maritime, a locally listed shipping trust. Its recent announcement of a 5 per cent rise in quarterly distribution payout saw its stock price appreciate correspondingly in the week the announcement was made.

Thus, it is imperative to know whether the company will be able to sustain its dividend payout over the long run since the occurrence of a potential double reward (or double whammy) is very dependent on the sustainability of the dividend payout. But how does one predict the dividend sustainability of a company?

There are a few crucial ratios that an investor should check out.

Payout Ratio

The first thing an investor should find out is the company’s payout ratio. There are two payout ratios that investors should compute. First, the payout ratio of dividends as a percentage of free cash flow, that is, net cash from operations minus net capital expenditure – simply put, how much money could the company take out each year and still keep its doors open. And second, the payout ratio of dividends as a percentage of net income. The latter will give investors the context for the dividend power of companies with lumpy capital expenditures.

The higher the payout ratio, the more likely it is that the dividend may not be sustained. A payout of more than 100 per cent is a warning sign that the company is paying out more than it earns. The lower the payout ratio, the greater the chance of the company sustaining or even increasing the dividends over time. The rule of thumb: a company with a payout ratio of 50 per cent or less is assumed to be more likely to sustain its dividends but do take note that this varies from company to company.

Other Ratios

Bear in mind, however, that the payout ratios for some counters like shipping trusts and real estate investment trusts are much higher compared to other companies. For example, in the case of shipping trusts in Singapore, the payout is typically more than 75 per cent of their incomes. This is mainly due to the inherent business model of business trusts which own assets that generate regular income flow for unitholders paid back in the form of regular dividends.

In that case, investors would want to look at the two other indicators to suss out the sustainability of the dividend payout – the debt to equity ratio and current ratio (current assets/current liabilities). Both of them are measures of assets relative to liabilities. A company that has a debt to equity ratio of over 100 per cent should raise the alarm bells since it means that it may be undertaking debt to sustain its dividend payout. A current ratio of more than one may give investors confidence as it shows that the company is in a good state of financial health and able to pay off obligations when it is due, thereby increasing the possibility of sustaining or even increasing its dividend payout in the near term.

There is no specific rule that applies to all companies. Thus it is pertinent for the investor to know the individual companies before applying those above-mentioned ratios. For example, a steady but slow-growing company in a mature industry that has little or no capital expenditure needs will be more able to sustain or raise its dividend compared to one pursuing aggressive expansion and growth.

Indeed, before investors get seduced by the attractively high dividend yields offered by the listed companies, it is imperative for them to duly check out the company’s payout, debt to equity, current ratios as well as its general financial health to ascertain if the dividends are sustainable before taking the plunge. Double reward or double whammy, it all depends on you.

The higher the payout ratio, the more likely it is the dividend may not be sustained. The lower the payout ratio, the greater the chance of the company sustaining or even increasing the dividends over time.