Cash flow from your investments is comfortable. However, for some this income is their livelihood. Here are some tools to measure and weigh dividend payments.
The last year has seen dividend payments become erratic as many companies either cut their payouts to zero or reduced it. Some listed companies, such as banks, were initially prevented from paying dividends by the South African Reserve Bank’s Prudential Authority. This restriction has now been lifted.
Dividends are an important part of a share’s return and for some investors it is essential, since they use their dividend income for general living expenses during retirement. It is important to understand the dividend policy of the company or sector you invest in. This will provide some insight into the risks of the dividend payments and how the businesses are performing.
Firstly, we have real estate investment trusts (Reits). These are property stocks listed on the stock exchange that meet the Reit requirements. One of these requirements is that they must pay out 75% of their distributable earnings, without attracting tax, as dividends and those payments are then taxed as income in the hands of the shareholders.
Dividend payments from Reits have generally been viewed as fairly safe, but 2020 showed that nothing is certain and some, such as Redefine, suspended their dividend entirely as they did not meet the requirements of the solvency and liquidity test laid down in the Companies Act. I did not think this excuse would pass muster, but it seems that the test supersedes the Reit requirements, and as such no dividend was paid. This was a shock to most Reit investors I spoke to, but ultimately the survival of the company is more important than a single dividend payment.
It is also important to note that while Reit dividends are taxed as income, all other dividends are taxed at a set 20% dividend withholding tax.
Remember that the Reit dividend payments are fully at the discretion of the company’s board. What we typically see is that the board will have a dividend policy whereby they will pay a set amount of each year’s headline earnings per share (HEPS) as a dividend. This is called the dividend cover ratio. So, say for example, a board has a dividend cover ratio of three times. Then a third of HEPS will be paid as a dividend per share.
I like this idea as it gives certainty in terms of how much profits will be paid out by the company. Now sure the HEPS will fluctuate, but a quality company will see the HEPS increasing over time and, therefore, shareholders can expect a similar increase in dividends.
The dividend cover ratio will also likely change over time. A smaller startup company may initially pay no dividends as profits are reinvested in the business for growth. Then as they grow and mature, these companies will start with a dividend cover ratio of say, five times, paying 20% of HEPS. As they then grow further, that cover ratio will reduce as more profits get paid out as a dividend.
There is also the concept of a progressive dividend policy in which a company increases their dividend every year by a set percentage, regardless of whether HEPS increases or decreases. The issue here is what happens in those years where HEPS grows less than the proposed percentage increase or, even worse, if HEPS drops? We have seen a few large-cap stocks try this on the JSE, but in the end they always abandon the idea as earnings growth declines or turns negative.
In the end dividends are great – until a pandemic arrives. But knowing the dividend policy of a company you are investing in remains important, as the trend of payments and adjustments to the dividend cover ratio show the maturing or failing of a business and this knowledge helps you understand potential future payouts.