Dividend payout and coverage

In simple terms

A dividend is cash paid to shareholders from a company's profits. Many investors value a regular dividend, but a dividend is only as good as the cash behind it. A company that pays more than it can afford will eventually have to cut, often at a bad time and with a sharp fall in the share price.

Two questions decide whether a dividend is sustainable: how much of its profit and cash the company pays out, and how much it needs to keep for the business.

Payout ratio and dividend cover

A payout ratio of 40% means the company pays out 40% of its profit and keeps 60%. Dividend cover of 2.5 times means profit could pay the dividend two and a half times over.

Compare with free cash flow too

Dividends are paid in cash, so the stronger test is whether free cash flow covers them.

How much should a company pay out?

There is no right payout ratio. It depends on what the company can do with the money it keeps.

• A company with good opportunities to reinvest at returns above its cost of capital, as the incremental returns lesson explains, may be right to pay little or nothing and grow faster.
• A mature business with few growth opportunities and steady cash flows can pay out most of its free cash flow.
• A cyclical business should be careful: a payout comfortable in a good year may be impossible in a bad one. Look at dividend cover in the worst year of the cycle.

A rising payout ratio over time, while profits stagnate, can mean the company is stretching to maintain its dividend.

Buybacks as an alternative

Companies can also return cash by buying back their own shares. Buybacks:

• Are flexible: a company can do one in a good year without committing to repeat it, unlike a regular dividend that shareholders expect to continue.
• Reduce the share count, so each remaining share owns more of the business.
• Help remaining shareholders only if the price is sensible. Buying back shares above their value transfers wealth to the shareholders who sell.

Buybacks also reduce equity, which raises ROE without improving the business. Tax treatment of dividends and buybacks differs for shareholders and is set by law, which changes; it is a separate question from whether the payout is sustainable.

When a high yield is a warning

Dividend yield is the dividend per share divided by the share price. A yield much higher than similar companies often means the market doubts the dividend will last: the price has fallen because profits are expected to fall, or because the payout looks unaffordable.

High yields are attractive only if the dividend is secure. Check cover by profit and free cash flow, debt levels and the trend in earnings before treating a high yield as a bargain. The yields lesson compares dividend yields with other yields.

Why it matters

Dividends are a real return to shareholders, and for many investors an important one. Judging whether a dividend can continue protects you from buying into a payout that is about to be cut, and helps you understand how a company balances rewarding shareholders today with investing for tomorrow.

Limitations

Payout ratios use one year's profit and dividends, both of which can be unusual. Special dividends from one-off gains can distort them. Some companies pay dividends partly from subsidiaries' cash or from past reserves, which may be sustainable for a while. Look at several years and read the company's stated dividend policy, which listed companies often publish.

Common mistakes

• Checking payout against profit only, not free cash flow.
• Buying a share just for a high yield without asking why the yield is high.
• Treating a low payout as bad, when the company may be reinvesting well.
• Ignoring buybacks when comparing how much cash companies return.

Try it yourself

Choose a listed company that pays regular dividends.

1. For the last five years, note dividends paid, net profit and free cash flow.
2. Calculate the payout ratio against profit and against free cash flow each year and for the five years in total.
3. Calculate the current dividend yield and compare it with similar companies.
4. Read the company's dividend policy, if published, and check whether its actual payouts match it.