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» Articles - Dividend Derivations
Dividend Derivations
It's no secret that I am a big fan of the much maligned dividend. Often overlooked, dividends are viewed as a small bonus at best or at worst, an inefficient diversion of corporate profits. This is a shame, for as we demonstrate in the DividendKey course, dividends not only account for a significant proportion of total return over the long term, but they also provide consistency of return (and as such lower risk), as well as compounding opportunities and tax benefits.
But what's more, and this is relevant for all investors, they offer deep insight into the health and prospects of a business. Indeed, it is their usefulness as an indictor of corporate strength that I want to discuss here. Regardless of whether you are specifically after income or not, the dividend history of a business can often give you much more information than a study of earnings alone and as such I believe all investors should consider them in their analysis.
Dividends aren't guaranteed
The first thing to understand is that listed companies are under no obligation whatsoever to pay a dividend; it is entirely discretionary. As a matter of fact the majority of listed stocks have never paid a dividend and even those that have in the past are not required to continue payments.
Understanding this we can already derive two important facts.
Firstly, to state the obvious, in order to pay a dividend a company must first generate an after tax profit. There are certainly exceptions where companies have had to fork out more than what they made in a given year (Telstra and Ten are examples), and this can be justified under certain circumstances. However the unavoidable logic is that over time a company must be profitable, and remain so, if it is to issue regular returns to shareholders.
So when I company has a record of regular dividend payments you have important evidence that it is a proven enterprise with a history of solid and reliable earnings. This may sound like an obvious criterion for investors, but we are all susceptible to the lure of a company seemingly on the verge of big things.
Unfortunately these stocks represent significantly higher risk and history has repeatedly demonstrated that even the most promising ventures can fail to live up to expectations.
Dividends signal financial wellbeing
The second deduction we can make is that a cash payment is a strong signal from management that they are confident of the businesses' future. Think about it; would a company continue to pay out much needed cash to shareholders if they felt their long term earnings were at risk? More often than not the urgency of the situation would prompt investment back into the business.
Recently we have seen many companies scale back their dividend in response to the GFC, but the better stocks maintained payments and several actually increased their payments (and many that did lower their payments did so only marginally). Doing so in an environment of uncertainty speaks volumes about managements confidence in the future, especially when many of their peers opted (or were forced) to cut payments. Again, there are always exceptions, but on balance the ability to maintain a dividend payment during periods of economic uncertainty is usually a very positive sign indeed.
Dividends discourage reckless behaviour
Another reason why a history of solid dividends tends to signal a quality stock is that it requires management to exhibit much higher standards of corporate self discipline. Although companies can change their dividends at any time, those with an attractive record are proud of it and understand that many shareholders view future payments as a major basis of ownership. As a result, well established businesses with a demonstrated commitment to shareholders expect to divert a significant proportion of their profits back to the ultimate owners of the business in the form of dividends (payout ratios above 50% are not uncommon for the larger cap stocks).
Of course, a business still needs to reinvest in itself just to maintain its capital base, and even the most established business will seek growth opportunities. But when a significant fraction of profit is returned to shareholders each year, management must be very diligent and sensible with the money that is left over.
Riskier ventures or acquisitions will be ignored, and management will be more focused on core areas of growth.
Dividends help with valuations
Finally, if we have good reason to expect that a business will remain profitable and grow even at average rates, we can use a commitment to dividends as a valuation tool. While we can't examine this in detail here, the basic premise is straightforward.
A company that is likely to pay out a similar dividend to what it paid last year will have a predictable yield based on current share price. For example, if a company is expected to pay a 10c dividend, and is trading at $2 we can assume we are likely to receive a yield of 5% in the first year. In an environment of low interest rates and with average market yields of closer to 3.5%, this represents an excellent opportunity, so long as we remain confident in the businesses long term viability.
Under such a scenario, it would be unlikely for the share price to fall significantly further; the efficiency of the market will generally not allow it. Of course the market is far from perfectly efficient in pricing assets, but it is generally true that solid return prospects are not usually ignored for long.
Dividend Payout ratios and expected yields can also illuminate for us the expected earnings of a business. This might at first look like a backwards way of going about things, after all couldn't we just look at the forecast earnings for the current year? Well the other thing we need to understand about dividends is that they are "sticky". Management knows that once a dividend level has been established, it's not easy to scale back. As we discussed earlier, it doesn't bode well for the health of a business or the income potential of the investment.
Every business experiences fluctuations in earnings and can be impacted by unexpected and market wide events, so when you arrive at earnings estimates based on payout ratios and dividend amounts you get a more accurate picture of sustainable earnings expectations. Short term impacts from extraordinary or significant items are ignored, as are seasonal and business cycle influences. Importantly, it can also help you see through overt market exuberance or pessimism and get a better idea of value.
Summary
So next time you are measuring up a potential investment, don't be so quick to gloss over the humble dividend. A study of dividends will tell you volumes about a company, and can help you identify those that represent attractive investments.
Remember that dividends are a cash payment, and cold hard cash deposited in your account is a clear and unambiguous signal of business confidence. Money talks and you know what walks!
If you would like to learn more about the power of rising dividends and how to select a balanced portfolio of quality income stocks, visit www.dividendkey.com today.
For more information, or to discuss your specific situation, please contact me directly.
Lachlan McPherson and Andrew Page
Market Analyst - Hubb Financial
