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Dividend quality – Do you have the knack of evaluating this before investing?

Oct 25, 2015 | Team Kalkine
Dividend quality – Do you have the knack of evaluating this before investing?

Introduction

In the low interest rate environment of the last few years, investing in dividend stocks have become popular as a method to achieve the best possible returns on investment to the extent that prices have, in some cases, driven to unrealistic levels. However, there is a crying need for investors to be able to distinguish between stocks that simply offer the highest dividend yields and stocks that offer the best quality dividend yields. In the quest for yields, there is often an understandable tendency for investors to think that the highest yields are the best. However, this approach can be highly dangerous because a solid but not sky high yield can reward investors with a sustainable and steady income stream and an abnormally high yield is often the result of a low share price which suggests that the market perceives poor prospects for the company and has priced the shares accordingly. As a result there will neither be sustainability or reliability about the dividend.
 

Understanding Dividend Quality

There are no hard and fast rules about dividend quality and no precise method of measurement in a scientific fashion. However, common sense suggests that it may be the sum total of a number of specific factors relating to a company such as the current levels of dividends, the forecast dividends and company performance which will determine the sustainability and reliability of the dividend. If the following factors leave you dissatisfied, you may wish to think again and reconsider your investment. For instance, dividend cover which can be simply calculated is a measure of the risk concerning your dividend. In the simplest form, it is the earnings per share divided by the annual dividend for whichever period you are considering though it is commonly calculated yearly. It can be calculated either on historical data or on the basis of forecasts. High quality dividends are normally covered comfortably by earnings in cash which means that the company is generating more than enough cash to be able to afford the payment of dividends. For instance, many experts believe that the number should be around 2 to 2.5 times because this will leave the company with enough cash to reward investors while leaving it with enough to finance its own growth and future prospects. The quality should be considered poor if the operating profit does not provide sufficient dividend cover because the company may be forced to deplete its cash holdings or sell assets in order to generate cash which does not augur well for the long-term future. These are distress signals as far as reliability and sustainability is concerned and should be taken into account.
 

Some Other Factors

Another factor to consider would be the dividend history of the company and the unique features of the Australian franking system. Your chosen company should have a history of paying dividends or even better, growing dividends every year. Obviously, you would not wish to invest in a company which has a history of skipping dividends or even slashing them. A one-off special dividend is obviously of much less value than a steady dividend that has been consistently paid over a number of years. Another important factor is the franking system that is unique to Australia so that you need to consider the gross dividend yield. In other words, you need to add the franking credits to get a true picture of the dividend. For instance, an investor who receives $ .80 per share may get a franking credit of $ .20 per share which makes the true value of the dividend $ 1 per share. You need to remember that franking credits are accumulated by the company on the basis of taxes paid in Australia and the company draws on this accumulation for franking credit payments. If the company is paying dividends at a high level or reducing its Australian tax payments, it could, in theory, be forced to reduce its franking levels. Of course, the reverse is also true.
 

Ramsay Health Care's Earnings per Share and Dividend Growth (Source: Company Reports)

In orthodox (and conservative) corporate finance theory, dividends should be paid out of earnings and the cardinal sin is to pay dividends out of capital. Therefore, it is reasonable to search for high yielding stocks which are forecast to increase earnings. This information is readily available through a number of sources online and it is important to remember that you are not looking for spectacular growth rates and you just need to satisfy yourself that the analysts predict steady real growth in earnings which will outpace inflation. It is also important to look at how quickly the company sends you the dividend cheque after the dividend announcement because this can take anything between four weeks and three months and you will benefit from quicker dividend payments.

There are other filters as well that can be used to screen the good quality dividend paying companies. These include return on assets, growth in net operating assets, and debt coverage ratio. In fact, debt coverage ratio will help evaluate a company’s distress risk and is primarily the ratio of available earnings for debt payments to the near-term debt burdens.
 

Looking at Dividends

Look for dividends on the basis of growth and strength, rather than those that are a financial strain on a company which probably should not be paying high dividends. For example, let's say that you’re considering buying two stocks in the same industry with similar growth projections. One recently paid a 5 percent dividend and other, 3 percent. But the 5 percent payer has a net profit of 6% and the 3 percent payer has a net profit of 10% which means that the lower payer actually has a greater potential for share price growth and sustained dividends. What’s more, this company may be reinvesting a larger part of its higher earnings in ways that will benefit shareholders in the long run. So the issue of which stock to buy can have little to do with dividend rates alone. The dividends they pay relative to earnings, considered along with the need to fund business strategies, is worth examining.
 
Finally, companies that pay dividends regularly and reliably are normally large and mature. However, there are also many small and medium-sized companies that have a good history of dividend payments though they may not have been around as long as some of the larger companies so that it’s possible to create a well-balanced portfolio of companies of different sizes in different sectors and industries which are good dividend payers. If you look for dividend quality, you are positioning yourself well for long-term value by way of long-term price appreciation while getting the benefits of a regular income stream.

Disclaimer
The advice given by Kalkine Pty Ltd and provided on this website is general information only and it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether the advice is appropriate to your investment objectives, financial situation and needs before acting upon it. You should seek advice from a financial adviser, stockbroker or other professional (including taxation and legal advice) as necessary before acting on any advice. Not all investments are appropriate for all people.Kalkine.com.au and associated pages are published by Kalkine Pty Ltd ABN 34 154 808 312 (Australian Financial Services License Number 425376).The information on this website has been prepared from a wide variety of sources, which Kalkine Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about any investments and we strongly suggest you seek advice before acting upon any recommendation.Kalkine Pty Ltd has made every effort to ensure the reliability of information contained in its newsletters and websites. All information represents our views at the date of publication and may change without notice. To the extent permitted by law, Kalkine Pty Ltd excludes all liability for any loss or damage arising from the use of this website and any information published (including any indirect or consequential loss, any data loss or data corruption). If the law prohibits this exclusion, Kalkine Pty Ltd hereby limits its liability, to the extent permitted by law to the resupply of services. There may be a product disclosure statement or other offer document for the securities and financial products we write about in Kalkine Reports. You should obtain a copy of the product disclosure statement or offer document before making any decision about whether to acquire the security or product.The link to our Terms & Conditions has been provided please go through them and also have a read of the Financial Services Guide. On the date of publishing this report (mentioned on the website), employees and/or associates of Kalkine Pty Ltd currently hold positions in:  BHP, BKY, KCN, PDN, and RIO. These stocks can change any time and readers of the reports should not consider these stocks as advice or recommendations.
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Kalkine is a trading name of Kalkine Pty Ltd ABN 34 154 808 312, which holds Australian Financial Services Licence No. 425376.
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