With interest rates at a record low, and bank deposits providing Australians little in the way of any meaningful reward, many investors are looking for an alternative place to park their funds. Dividend-paying companies like Commonwealth Bank (ASX: CBA), Sydney Airport (ASX: SYD) and Rio Tinto (ASX: RIO) have long been favourites of those investing in shares to support their retirement.
In addition, Australia’s investor-friendly taxation system ensures that many shareholders can take advantage of franking credits – tax already paid by a company – to reduce their taxable income. Since the 1980s, the All Ordinaries has traded with an average dividend yield of approximately 4.1%. This compares favourably to a yield of 2% for the S&P 500, and that’s before franking credits are taken into consideration.
For some, in today’s low-growth economic environment, investing in shares that pay dividends holds even more appeal. However, the allure of these dividends can sometimes draw investors into a stock, only to realise that for a variety of reasons, those dividends are no longer. After all, the past is not a reliable indicator of the future.
It’s one thing to find shares paying high dividends, but how do you identify sustainable dividends? Here are some of the key things to look for.
Shares with a healthy payout ratio
The payout ratio is a representation of what proportion a company’s earnings are paid as dividends. For example, if a company earns $1 per share but pays $0.80 per share in dividends, its payout ratio is 80%. Across the ASX, the dividend payout ratio currently averages around 70%.
This metric can be a useful gauge to identify sustainable dividends. Generally, if a company has a very high payout ratio – for example, above 95% – its dividends might not be sustainable over the long-term. When investing in shares, it’s also important to realise there are differences between industries. With real estate investment trusts (REITs), these stocks often boast dividend payout ratios of a high magnitude. For most companies, if this ratio remains elevated, and earnings start to decrease, not only is a dividend cut possible, but there may be broader concerns as well.
One of the reasons for this would be the small earnings retained by the company to re-invest in the business. It may translate into a scenario where the company has limited means to continue growing, or difficulty adapting to any emerging challenges. Westpac (ASX: WBC) is one recent example. Having paid out 98% of its earnings as dividends in the first half, just last week the bank was forced to cut its dividend amid slowing growth. The opposite applies to companies that grow their earnings, giving them scope to increase dividends.
Companies with strong free cash flow
Some of the highest-quality shares listed on the ASX have impressive records of generating strong free cash flow. This is how much cash the company derives after its operational spending requirements and any capital expenditure towards its assets, which you can calculate from the balance sheet. Many investors look at free cash flow for an indication where the company’s strategic priorities lie.
Where a company draws down a large portion of free cash flow to pay dividends, it may raise questions as to the sustainability of this practice. Many investors prefer to see this cash diverted towards growth initiatives – where returns may compound each successive year – or towards the balance sheet, in order to reduce pressure.
Nonetheless, a company with sufficient free cash flow to cover dividend obligations is more likely to offer sustainable dividends, or even increase them over time. In some instances, businesses may be able to pay dividends without free cash flow, however, this is unlikely to be sustainable over the long-term.
Businesses that can service their debt
The next time you log into your trading account, look at the debt for each company you hold. Investing in shares with debt or borrowings is not necessarily a reason to be concerned. In fact, most companies have some debt on their balance sheet to drive earnings growth. However, it is beneficial to look closely at a company’s record when servicing its debt.
If a business does not make regular efforts to pay down its debt, it can sometimes put pressure on the balance sheet. If there is insufficient free cash flow to service debt, then a company may approach the market for dilutionary funding, or look at other areas to preserve cash. This could mean dividends are one of the first outflows to be pared back. With that, businesses leveraging debt to pay their dividends should not be relied upon for a sustainable yield, particularly in a deteriorating operating environment.
Shares with a bright growth outlook
Each of the above factors should also be considered with respect to the future. Sometimes the outlook of a company, or the environment in which it operates is likely to materially change. In such circumstances, investors should be wary of falling victim to ‘yield traps’. This is where a falling stock trades with a high yield because investors predict earnings to drop and the company may cut dividends. On the contrary, investors should be looking for companies growing year in, year out.
At the same time, focusing exclusively on dividend-paying stocks is likely to be an unwise approach. However, by delving deeper into the numbers, you can determine whether you are investing in shares generating sufficient earnings and free cash flow to pay sustainable dividends. While nothing is certain in the share market, prudent research can go a long way to protect the value of your portfolio.
SelfWealth Ltd ACN 52 154 324 428 (“SelfWealth”) (Australian Financial Services Licence Number 421789). The information contained on this web site is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. Taxation, legal and other matters referred to on this website are of a general nature only and should not be relied upon in place of appropriate professional advice.