We are using a dividend approach for our investing accounts and until recently we have made out quite well. But now, too often the dividends are not beginning to make up for the loss in the value of the shares. Are there certain ratios or tools you use to identify which securities are more likely to avoid this fate?
In my Yield Hog columns, I examine companies from a number of different angles. Among the factors I consider are the company’s earnings growth prospects, stock valuation, yield, dividend growth outlook, dividend payout ratio, analyst ratings and management track record.
But even the best companies stumble now and then. They’ll have a bad quarter or their shares will be hit by rising interest rates – a familiar theme recently. Sometimes, even when a company is doing everything right, its shares will still get clobbered. When the market decides to plunge – as it did this week – no company is safe.
You mentioned that you have, until now, “made out quite well.” That’s great. However, it’s unreasonable to expect your stocks to do well all of the time. It’s also arbitrary to compare a company’s dividends with a short-term drop in its stock price and assume that if the former doesn’t make up for the latter something must be wrong. I suspect you’re connecting these two things in your mind because you don’t like the idea of experiencing even a paper loss.
If you want to avoid market turmoil altogether, you could invest in guaranteed investment certificates. But if you are going to own stocks – and I strongly believe most people should own some, either directly or through funds – there really is no way to avoid volatility and short-term losses. They are the price you pay for the superior long-term returns that equities deliver. Learning to live with volatility – not escape it – is one of the secrets to building wealth.
It can be helpful, during times such as these, to focus on the income your stocks are producing. Dividends are far more stable than share prices, and over the long run – again, assuming you hold high-quality companies – your dividend income will rise steadily. Knowing that your cash flow is secure and growing can be a great source of comfort when the market is experiencing one of its periodic – and unavoidable – bouts of turbulence.
For dividends to be sustainable, shouldn’t the payout ratio be less than 100 per cent? For example, Brookfield Infrastructure Partners LP (BIP.UN) pays out well in excess of 100 per cent of its earnings. Does this mean a distribution cut is inevitable?
To determine the sustainability of a dividend, you need to examine companies on a case-by-case basis. Payout ratios can be measured in many different ways, and an acceptable payout ratio for one company might be a sign of trouble for another, depending on the industry, nature of the business and stage of growth. For these reasons, you need to dig deeper than the payout ratios provided on third-party financial websites.
Consider Brookfield Infrastructure. For the six months ended June 30, BIP distributed 94 U.S. cents per unit, yet its net income per unit was just 63 U.S. cents. On this basis, BIP’s payout ratio is close to 150 per cent, which seems like an accident waiting to happen.
However, earnings often contain non-cash accounting charges that may not affect a company’s ability to pay or sustain dividends. That’s why BIP – which owns a lot of large, long-lived infrastructure assets – calculates its payout ratio based on a cash flow measure called funds from operations (FFO), which excludes depreciation, amortization, deferred income taxes and other non-cash items.
Based on FFO, BIP’s payout ratio for the first six months of 2018 was a much more reasonable 59 per cent, which is slightly below BIP’s long-term FFO payout target range of 60 per cent to 70 per cent. In fact, for the past five fiscal years, BIP’s FFO payout ratio has been smack in the middle of that range, averaging 65 per cent.
It wouldn’t be fair to ignore depreciation altogether. After all, BIP has to spend money to maintain its toll roads, gas pipelines, electricity transmission lines and other infrastructure assets. To reflect such costs, BIP also calculates a more stringent payout ratio based on adjusted funds from operations (AFFO), which includes capital expenditures required to maintain its assets. Over the past five years, BIP’s AFFO payout ratio has averaged 79 per cent, which still provides a nice cushion. Indeed, BIP has raised its distribution for nine consecutive years, and I expect another increase early in 2019.
Bottom line: If you’re wondering about the sustainability of a dividend, there is no substitute for reading through the company’s financial statements, investor presentations and other material to see how the company measures its payout ratio and whether it is hitting its targets. The payout ratio on financial websites won’t give you a complete picture.
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