A guide to dividends
Updated
As a shareholder you could also be entitled to a dividend, which is the official name for what a company pays out to the shareholders and this payout will vary from company to company. Dividends should not be ignored as they can contribute to a large chunk of total returns. Dividends are on of the two main ways of a company to return money to their shareholders.. The other way is through buybacks.
As previously stated a dividend is money that the company returns to its shareholders. Usually, dividends are payed out at certain regular intervals and the total dividend payed can go up and down depending on how well the company is doing. Occasionally, a company can pay a one off dividend called a special dividend and this usually happens when a company has had an exceptionally good year, or has excess cash after the disposal of an asset and wants to return some money to the shareholders without changing the (regular) dividend payment too much.
Dividends are calculated as a percentage yield (dividend / market cap x 100) and can fluctuate with the changes in the share price even if the dividend remains constant. For example if a company valued at 100 million and pays out 10 million in dividends then its yield is 10%. Should the value of the company increase by 100% over the next year, but the dividend remain constant the yield is now 10,000,000 / 200,000,000 x100 = 5%. Should the value of the company subsequently double again in the next year, and the dividend rise by 50% the percentage yield will fall again (despite the actual payouts rising) to 3.75%. It is worth noting that whilst I have used market cap and total dividends paid to assess the yield it is more commonly done on a per share basis, but this does not affect the percentage yield.
It is worth noting that the dividend of a company can vary greatly from company to company and from sector to sector some may decide not to pay a dividend altogether and others may decide to pay a dividend in excess of 10%. Dividends are very closely followed by some investors, although personally I believe that the importance of a dividend can be exaggerated. Dividends are popular as they provide a regular source of income and a higher dividend being better, however it is possible to create a source of income by selling some of the portfolio instead, therefore, when assessing a company a dividend is not crucial. Moreover, a dividend is just the transfer of cash from the corporations bank account to yours, meaning that there is not real gain (or destruction) of value. Having said that, a divided can be a good barometer of a company’s health. If a company has been raising its dividend for several consecutive years it could be worth a good look as it implies that the company is doing well.
When looking at a dividend you not only have to check how high the yield is, but also wether it is sustainable and wether it could grow over time.
The most popular metric for assessing wether a dividend is sustainable is dividend cover ratio. It is calculated by dividing eps by the dividend per share. A dividend that is covered less than once is considered to be unsustainable (most of the time) as the dividends are larger than the profits, and preferably a dividend should be covered at least twice leaving the company money for other purposes, such as expanding or paying down debt.
However, when assessing how sustainable a dividend is I would prefer to use free cash flow rather than net income (net income = eps x total number of shares outstanding net income is a way of looking at eps as a market cap as a whole.) Free cash flow is calculated by subtracting cash flow from capital expenditures from operating cash flow. This is an extremely useful figure as it shows how much excess cash has been generated by the company. The reason why I use cash flow instead of earnings is due to the fact that dividends are paid in cash and so it makes sense to how much cash has been generated rather than earnings. I specifically use free cash flow rather than any other cash metric as free cash flow shows how much can be spent without impeding in operations and growth, therefore I would like to see a dividend covered at least once by free cash flow so it has excess cash to spend on other uses such as paying down debt or spending money on acquisitions.
To assess wether a dividend is sustainable I have assembled a 9 point test (including free cash flow cover):
• Free cash flow covers the dividend at least once (bonus point if covered twice)
• Current ratio of at least 1. Implies that is has a strong working capital position and has the ability to pay its bills.
• Has raised the dividend for the last 3 years or has not cut it in the past 5 years. Implies that the dividend is unlikely to be cut in the future as it has not been in the past.
• Debt to equity ratio of no more than 2 Implies that the company has a strong balance sheet and is not going to cut the dividend in order to pay off debt.
• Free cash flow (per share diluted) has increased from 1 year ago Implies that the company is doing well
• Has not issued new shares in the past year Implies that is is strong financially and does not rely on external resources of finance.
• Has lower debt than last year Implies that the company is able to lower debt and be financially sound.
• Net debt is no more than 4 times free cash flow Implies that debt is not too high
• Has an interest coverage of free cash flow of at least 3 Again implying that interest on debt is not eating away at returns that could be funding dividends.
It is very important to distinguish the difference between returns and share price gains. A company or index may not seem to be performing well, when actually it is as this money is being payed out as dividends. Gains from dividend payments are just as important as share price gains and so should not be forgotten
It is also worth paying attention to the fact that dividends can compound over time and so returns are higher if the money is reinvested rather than uninvested. To highlight this let’s assume that you invest in a share that pays a 5% dividend and the share price increases by 5% every year. Let’s also say that the dividend increases at a rate of 5% a year meaning that the percentage yield will remain constant. Assuming the share price of the company is initially 100p. Dividends uninvested:
Year No. Dividends received (p) Share price (p) Total return (p)
0 0 (+0) 100 100
1 5 (+5) 105 110
2 10.25 (+5.25) 110.25 120.5
3 15.76 (+5.51) 115.76 131.52
4 21.55 (+5.79) 121.55 143.1
5 27.63 (+6.08) 127.63 155.26
6 34.01 (+6.38) 134.01 168.02
7 40.71 (+6.70) 140.71 181.42
8 47.75 (+7.04) 147.75 195.5
9 55.13 (+7.38) 155.13 210.26
10 62.89 (+7.76) 162.89 225.78
However, if you reinvested the dividends, the return would be 10% annually and after 10 years the total return would be 259.37p compared to the 225.78 with dividends uninvested, almost 15% higher. Dividends reinvested:
Year No. Total return
0 100
1 110
2 121
3 133.1
4 146.41
5 161.05
6 177.16
7 194.87
8 214.36
9 235.79
10 259.37
It is also worth noting that the date people are required to be shareholders and the date the actual dividend is payed are not the same. There are 4 important dates that you need to bear in mind when considering the dividends. The first is the dividend declaration date, this is when management actually announce their decision to pay the dividend, they will also state the size and the record date. The second is the ex-dividend date which is one (working) day before the record date, the date where management note who to pay the dividend to – the people on the shareholder list. To be entitled to a dividend it is required to buy at least the day before the ex-dividend date, I,e two days before the record date, this is because to get onto the shareholder register in time it takes 2 working days after buying . Finally, we also have the payment date, where the actual dividend is payed. It is worth noting that you are not obliged to hold onto the shares to receive a dividend, as long as you were in the shareholder register on the record date, you will be entitled to the dividend, so if you sold shares on the ex-dividend date or after you will still get the dividend. Having said that, receiving the dividend (or missing out on the dividend) does not change much, as the share price will on average fall by as much as the dividend, due to the fact that new buyers will not be entitled to a dividend.
As previously stated a dividend is money that the company returns to its shareholders. Usually, dividends are payed out at certain regular intervals and the total dividend payed can go up and down depending on how well the company is doing. Occasionally, a company can pay a one off dividend called a special dividend and this usually happens when a company has had an exceptionally good year, or has excess cash after the disposal of an asset and wants to return some money to the shareholders without changing the (regular) dividend payment too much.
Dividends are calculated as a percentage yield (dividend / market cap x 100) and can fluctuate with the changes in the share price even if the dividend remains constant. For example if a company valued at 100 million and pays out 10 million in dividends then its yield is 10%. Should the value of the company increase by 100% over the next year, but the dividend remain constant the yield is now 10,000,000 / 200,000,000 x100 = 5%. Should the value of the company subsequently double again in the next year, and the dividend rise by 50% the percentage yield will fall again (despite the actual payouts rising) to 3.75%. It is worth noting that whilst I have used market cap and total dividends paid to assess the yield it is more commonly done on a per share basis, but this does not affect the percentage yield.
It is worth noting that the dividend of a company can vary greatly from company to company and from sector to sector some may decide not to pay a dividend altogether and others may decide to pay a dividend in excess of 10%. Dividends are very closely followed by some investors, although personally I believe that the importance of a dividend can be exaggerated. Dividends are popular as they provide a regular source of income and a higher dividend being better, however it is possible to create a source of income by selling some of the portfolio instead, therefore, when assessing a company a dividend is not crucial. Moreover, a dividend is just the transfer of cash from the corporations bank account to yours, meaning that there is not real gain (or destruction) of value. Having said that, a divided can be a good barometer of a company’s health. If a company has been raising its dividend for several consecutive years it could be worth a good look as it implies that the company is doing well.
When looking at a dividend you not only have to check how high the yield is, but also wether it is sustainable and wether it could grow over time.
The most popular metric for assessing wether a dividend is sustainable is dividend cover ratio. It is calculated by dividing eps by the dividend per share. A dividend that is covered less than once is considered to be unsustainable (most of the time) as the dividends are larger than the profits, and preferably a dividend should be covered at least twice leaving the company money for other purposes, such as expanding or paying down debt.
However, when assessing how sustainable a dividend is I would prefer to use free cash flow rather than net income (net income = eps x total number of shares outstanding net income is a way of looking at eps as a market cap as a whole.) Free cash flow is calculated by subtracting cash flow from capital expenditures from operating cash flow. This is an extremely useful figure as it shows how much excess cash has been generated by the company. The reason why I use cash flow instead of earnings is due to the fact that dividends are paid in cash and so it makes sense to how much cash has been generated rather than earnings. I specifically use free cash flow rather than any other cash metric as free cash flow shows how much can be spent without impeding in operations and growth, therefore I would like to see a dividend covered at least once by free cash flow so it has excess cash to spend on other uses such as paying down debt or spending money on acquisitions.
To assess wether a dividend is sustainable I have assembled a 9 point test (including free cash flow cover):
• Free cash flow covers the dividend at least once (bonus point if covered twice)
• Current ratio of at least 1. Implies that is has a strong working capital position and has the ability to pay its bills.
• Has raised the dividend for the last 3 years or has not cut it in the past 5 years. Implies that the dividend is unlikely to be cut in the future as it has not been in the past.
• Debt to equity ratio of no more than 2 Implies that the company has a strong balance sheet and is not going to cut the dividend in order to pay off debt.
• Free cash flow (per share diluted) has increased from 1 year ago Implies that the company is doing well
• Has not issued new shares in the past year Implies that is is strong financially and does not rely on external resources of finance.
• Has lower debt than last year Implies that the company is able to lower debt and be financially sound.
• Net debt is no more than 4 times free cash flow Implies that debt is not too high
• Has an interest coverage of free cash flow of at least 3 Again implying that interest on debt is not eating away at returns that could be funding dividends.
It is very important to distinguish the difference between returns and share price gains. A company or index may not seem to be performing well, when actually it is as this money is being payed out as dividends. Gains from dividend payments are just as important as share price gains and so should not be forgotten
It is also worth paying attention to the fact that dividends can compound over time and so returns are higher if the money is reinvested rather than uninvested. To highlight this let’s assume that you invest in a share that pays a 5% dividend and the share price increases by 5% every year. Let’s also say that the dividend increases at a rate of 5% a year meaning that the percentage yield will remain constant. Assuming the share price of the company is initially 100p. Dividends uninvested:
Year No. Dividends received (p) Share price (p) Total return (p)
0 0 (+0) 100 100
1 5 (+5) 105 110
2 10.25 (+5.25) 110.25 120.5
3 15.76 (+5.51) 115.76 131.52
4 21.55 (+5.79) 121.55 143.1
5 27.63 (+6.08) 127.63 155.26
6 34.01 (+6.38) 134.01 168.02
7 40.71 (+6.70) 140.71 181.42
8 47.75 (+7.04) 147.75 195.5
9 55.13 (+7.38) 155.13 210.26
10 62.89 (+7.76) 162.89 225.78
However, if you reinvested the dividends, the return would be 10% annually and after 10 years the total return would be 259.37p compared to the 225.78 with dividends uninvested, almost 15% higher. Dividends reinvested:
Year No. Total return
0 100
1 110
2 121
3 133.1
4 146.41
5 161.05
6 177.16
7 194.87
8 214.36
9 235.79
10 259.37
It is also worth noting that the date people are required to be shareholders and the date the actual dividend is payed are not the same. There are 4 important dates that you need to bear in mind when considering the dividends. The first is the dividend declaration date, this is when management actually announce their decision to pay the dividend, they will also state the size and the record date. The second is the ex-dividend date which is one (working) day before the record date, the date where management note who to pay the dividend to – the people on the shareholder list. To be entitled to a dividend it is required to buy at least the day before the ex-dividend date, I,e two days before the record date, this is because to get onto the shareholder register in time it takes 2 working days after buying . Finally, we also have the payment date, where the actual dividend is payed. It is worth noting that you are not obliged to hold onto the shares to receive a dividend, as long as you were in the shareholder register on the record date, you will be entitled to the dividend, so if you sold shares on the ex-dividend date or after you will still get the dividend. Having said that, receiving the dividend (or missing out on the dividend) does not change much, as the share price will on average fall by as much as the dividend, due to the fact that new buyers will not be entitled to a dividend.
Note
Also, in general during times of high inflation (and most importantly high interest rates) high yielding or income stocks are hurt more than others as the income stream looks less attractive. Why take the risks of buying an income stock when safe havens pay interest that is just as good?
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