finweek

Why you need to understand a company’s payout policy

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Dividends are great. 

I call them free money, albeit you’re receiving it because you bought a dividend-paying share. 

The real beauty is that you’ll continue to receive that dividend for as long as you hold the stock and the company continues to pay dividends. 

After a decade or two, the dividends you earn on a particular share could potentially exceed the amount you actually paid for it; and those dividends will keep on coming every six months or annually, depending on the company’s dividend policy.

That dividend policy is what I want to focus on in this column. 

When buying a share, many investors tend to largely ignore the dividend, as the dividend yield (yield is the size of the dividend relative to the share price expressed as a percentage) is most often fairly modest. 

For example, a 2.5% dividend yield means that an investment of R10 000 will get you a modest R250 in the first year. 

But assuming the company is strong, and is growing profits ahead of inflation, that annual R250 will rise every year – potentially doubling every five years if, say, an annual 15% increase is sustained.

So, even if they are small to begin with, dividends offer two important things to investors. 

Firstly, they add to the total return for an investment. Sure, price movement is usually greater than the dividend payment, but even an extra 2.5% a year in dividends is not insignificant. 

Secondly, dividends provide cash flow. The only other way an investor can realise cash from an investment is through selling some, or all, of their holdings. 

That’s why investors need to focus more on dividends, as well as the potential growth of a dividend, as well as any threat of it being reduced or cancelled.

Most listed stocks will have a dividend policy whereby they pay out a certain percentage of profits or headline earnings per share (HEPS) as a dividend. 

So, if the payout ratio is 50%, then half the HEPS will be paid as a dividend while the other half will be retained by the company. 

A 75% payout ratio will mean three-quarters of profits are paid out as dividends and a quarter is retained.

I like a consistent dividend policy as it gives me a level of certainty about the dividend, subject of course to what’s happening to the profits. 

Some boards will also adjust this policy over time, increasing the payout ratio as profits grow and the company matures.

One red flag to watch out for is a company using debt to pay dividends. This is never, under any circumstances, a good idea. Rather cut the payout ratio, or even just cut the dividend entirely. Never borrow to fund dividends.

Another policy some boards implement is a progressive dividend, which means that the dividend will be increased by a certain percentage every year, regardless of profits. 

I hate this idea because at some point profits could slow and suddenly the company finds itself in a bind, and then the policy needs to be revoked. Or, if profits soar, the dividend lags due to the set increase every year.

A last point on dividends is tax. Dividend withholding tax (DWT) is a flat 20% in South Africa, and that’s high. 

Capital gains tax (CGT), for which you are liable when you sell an investment, is a maximum of 18% – if you’re earning over R1.5m a year and paying personal income tax at a rate of 45%. 

Furthermore, the first R40 000 you receive when selling your investment is exempt from CGT, which again emphasises how steep that 20% DWT is.But, as writing this column reminds me, tax is a by-product of success. 

If I want to pay less tax, then I should simply make less money. So, I grit my teeth and pay the tax.

This article originally appeared in the 6 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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