Thursday, 28 April 2016

[Opinion] What is a sustainable dividend?

I have been agonising over the perfect post for the last few weeks. How do I get people's attention? I wanted a blockbuster post. A post that unveils some universal truth. I soon drifted back to reality and realised that I could spend the rest of my life trying to achieve this goal. I think it is more useful just to write, share and engage regularly with people who are kind enough to follow my blog.

So I will write once or twice a week. Sometimes posts will be long, sometimes they will be short. Sometimes they will be opinion-based, sometimes they will be fact-based. Sometimes they will be right, sometimes they will be wrong. Ok, you get the drift. The most important thing is to write.

Tonight, I'd like to talk about sustainable dividends. I got the inspiration for this post from Dividend.com. There is an article on payout ratios here.

Basically, how do you know that a company can keep paying you a dividend? Of course, you can never know for sure - we are looking into the future after all. One of the clues a company gives you is its payout ratio or the inverse, which I prefer, the dividend coverage ratio. The dividend coverage ratio is simply the:

Earnings per share / Dividends per share
A dividend coverage ratio of less than 1 means that a company is paying out more than it earned in the current year. Obviously, a ratio greater than 1 means it has paid less than it earned for the current year. As a general rule, you want the ratio to be greater than 1. This means that company is able to reinvest some of its profits back into the business to generate a return. I say "general rule" as there are various situations where a company shouldn't be doing so (e.g. where a companies cost of capital exceeds the expected return on the reinvested profit but this is another blog post). Also, different industries can require different coverage ratios based on levels of investment needed.

The takeaway is this:

If the company is paying you more in dividends than they are earning there is a problem