Dividend Sustainability
Dividend Sustainability refers to a company's ability to maintain its current dividend level in the future.
π Definition
What is Dividend Sustainability?
Dividend Sustainability refers to a company's ability to maintain or increase its current dividend payments without cutting them in the future. For investors, a 'dividend cut' is the most fearsome enemy, often resulting in both a stock price crash and a reduction in income. Therefore, it is essential to look beyond the dividend yield and verify how strongly that dividend is supported by earnings and cash flow.
Highly sustainable companies possess robust financial structures and business models that allow them to maintain dividends even during temporary economic downturns.
In Simple Terms
Understanding it Easily
Dividend sustainability is like 'surplus funds in a household budget.' One household might save (pay dividends) $5,000 every month, but they might actually be borrowing money to do so. Another household might only save $2,000, but it's from money left over after all living expenses are paid. If income suddenly drops, which household can continue saving?
Obviously, the household that saves from leftover money. Companies are the same. The key to sustainability is checking whether the amount going out as dividends is not too high relative to the money earned (profit).
Example
Case Study and Analysis
During the pandemic, many airlines and hotel companies suspended dividend payments (dividend cut) as soon as their earnings deteriorated. This was because they were vulnerable to economic fluctuations, resulting in low dividend sustainability. On the other hand, companies like Johnson & Johnson (J&J) or Coca-Cola have not stopped dividends even through decades of crises.
"A safe dividend is a hundred times better than a flashy yield. Unsustainable high dividends are like a poisoned chalice."
π‘ Practical Tips
- 1Payout Ratio: The ratio of dividends to net income. Usually, below 60% is safe, while for REITs, below 90% of AFFO is typical.
- 2FCF Payout Ratio: It is more accurate to look at how much actual cash is left (Free Cash Flow) than accounting profit.
- 3Interest Coverage Ratio: Check if the company is earning enough to cover its interest payments to assess debt risk.
- 4Cash Reserves: Verify if there's enough cash on hand to weather a crisis.
β οΈ Common Mistakes
Watch Out: The Trap of Temporary Profits
In years when net income spikes due to asset sales or one-time compensation, there can be an illusion that the payout ratio is low. Do not mistake this for an improvement in the company's core business. You must check the long-term trend of whether operating profit is occurring steadily.