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How to determine if a company's dividend is sustainable

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How to determine if a company's dividend is sustainable.

With interest rates falling to abnormally low levels and set to go even lower, many investors are turning to shares to generate income. The New Zealand sharemarket has been a clear beneficiary of this trend outperforming other markets thanks to its attractive dividend yields.

However, investors need to be careful when buying a share for its dividend characteristics. On one hand we should expect that the directors of a company will only set a dividend that they're confident they can maintain. But in a world where the market rewards companies with high dividends it can be tempting for companies to do all they can to lift dividends — sustaining them over time may become an issue.

There are a variety of ways higher dividends can be achieved by eroding the future profitability of the business. A manufacturer could direct all spare cash to dividends and fail to set aside money for new product development. A property company could pay out all rents as dividends and then be short of cash when a building inevitably needs maintenance. A bank could pay a hefty dividend and not make sufficient provision for when some of the loans don't get repaid on time.

Techniques to help understand how sustainable a company's dividend include looking at the payout ratio. This is the portion of a company's profits that are paid out as dividends. A payout ratio close to 100% indicates that the company has very little left over to invest for growth or to provide a buffer in tough times.

We can also look at the dividend compared to the company's free cash flow per share. For example the company might be making profits but not generating much cash. In this situation, dividends will have to be funded by increasing debt in the business, or by raising more capital from shareholders.

We're seeing a stream of new investments coming to market which heavily promote their yield to investors. Before investing in such products it's important to understand what the true sustainable yield is; otherwise you may be paying for an income which isn't really income at all. The allure of an attractive dividend should not get in the way of sound analysis of the sustainability of that dividend.

 

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