I am a roaring skeptic when it comes to dividends.
Firstly, I think dividend yields, like the price-to-earnings ratio, contain limited value because they only reflect what has happened in the past. But I also find that dividends have a dangerous knack of masking all manner of business risks and management sins.
I shudder to think how many investors have been enticed by the trailing dividend yields of AMP Limited (ASX: AMP) and Telstra Corporation Ltd (ASX: TLS) in the past, only to see the dividends cut or the share prices incinerated.
I take 3 specific steps to avoid getting caught out when looking for dividends:
1. Read the dividend policy
All businesses have different approaches to paying out dividends to align with their own unique business cycles. I always start by reading the company’s dividend policy so I know what to expect.
Often companies have a target payout ratio, for example SkyCity Entertainment Group Limited (ASX: SKC), which aims to pay a minimum NZD 20 cents per share, or 80% of normalised net profit after tax (NPAT). But other companies tailor their policy to their capital spending needs or growth profiles.
2. Consider if the dividend is sustainable
A dividend that gets cut usually brings with it a double blow. Firstly, there is no payout, but on top of that the share price often gets ransacked. The test I use is to look for companies with a sustainable competitive advantage or pricing power.
Utilities, like airports, and essential services like healthcare company Ramsay Health Care Limited (ASX: RHC), often fall into this category. Niche market segments or monopoly positions help to ward off new competitors. They can also smooth the impact of economic cycles to maintain the cash flows for dividends.
3. Focus on the cash flow, not the profit
I always, always check a company’s statement of cash flow ahead of its profit line.
A red flag for me is when a company is not producing enough cash from operations to cover the dividend. This could mean the cash is coming from financing cash flows, which is unlikely to be sustainable.
On the flip side, capital intensive companies, like utilities or energy producers with significant assets, often produce much more cash than they report in profit. This is because of the way depreciation impacts profit on the income statement, but not cash flows.
Remember, the reason companies pay dividends is because they have more cash than they need or can invest profitably. Because these businesses are often mature, we want to be as sure as possible they can continue to produce cash long into the future.
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You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia owns shares of and has recommended Telstra Limited. The Motley Fool Australia has recommended Ramsay Health Care Limited and Sky City Entertainment Group Ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.