Look at the ratios for dividends-24th May 2003

Annette Sampson - Sydney Morning Herald

Now you see them, now you don't. Companies which pay decent dividends have become a safe haven for sharemarket investors in the past couple of years. The logic is that even if share prices continue to fall, investors are guaranteed at least some return on their money through the payment of dividends. Eventually, the argument goes, share prices will recover to reflect the return available from the dividend income.
As a strategy it makes a lot of sense. There's just one proviso. If investors are to get the returns they count on, the companies they invest in must keep paying, and growing, their dividends.

Unfortunately, this doesn't always happen. This week Southcorp said it won't pay a dividend this half and analysts have been reducing their forecasts for future AMP dividends (partly due to pressure on earnings and partly thanks to the dilution effect of all those new shares it's issuing). Last year, Village Roadshow shocked investors by saying it would stop paying dividends, and a number of smaller companies have suspended or reduced dividends.

For many investors this put the cap on a lousy couple of years. Having suffered big capital losses, they are deprived of income as well. So is there any way of safeguarding against these nasty experiences? Sadly, nasty shocks are part and parcel of investing. Even the best informed investors never have all the information they need to make a fool-proof decision. Circumstances can change and the unexpected can happen. What smart investors do is to try to reduce the risks of investing, while accepting they can't eliminate them.

Peter Thornhill of Motivated Money believes many investors have been caught by chasing yields rather than investing for income. While the two sound the same, he says astute investors realise that it's often better to invest in a company with a modest yield at the outset, but the potential to grow its earnings, than in a company with a high yield and limited or no profit growth potential.

That means looking at the company's management and business, as well as the industry and general economic environment it's operating in, and assessing whether it's likely to come under pressure in the medium to longer term.

Signs that a company might not be able to sustain its dividends include a high level of competition and/or oversupply in its industry, emergence of new technologies that will replace what it's selling, a trail of poor management decisions and/or unstable management, and economic trends with a negative impact on the business. There are more.

There are also some financial ratios that can help. Cavil Singh, the head of broking investment services with Godfrey Pembroke, says the two most important are the level of dividend cover and the dividend payout ratio.

Dividend cover is basically calculated by dividing earnings per share into the dividend per share. Let's take one company that is under pressure from tough times in its industry Qantas. Singh says that, barring an oil price shock or a worse than expected fallout from SARS, Qantas is expected to earn 36c a share next year and pay 21c in dividends. So its level of dividend cover is 1.7 times. In other words, it is expected to earn 1.7 times its dividend.

For investors this means a bit of a safety net in the Qantas dividend. Earnings per share would have to fall short by more than 40 per cent before it earned less than it was expected to pay out.

On that basis, you'd expect Qantas to be able to meet its dividend forecast if its profits came in a bit lower than expected, though a big profit fall would jeopardise the dividend.

But that's only half the story. The dividend payout ratio calculates how much of its profits a company is paying out as dividends. Obviously a lower payout ratio is better than a high one, as the company may be able to lift its payout ratio in bad times to avoid reducing its dividends.

You calculate the payout ratio by dividing the dividend into earnings per share. That gives Qantas a payout ratio of a bit less than 60 per cent. Again, there's a bit of a buffer for the company to sustain the dividend if things are worse than expected.

Singh emphasises these ratios aren't foolproof a company, may, for instance, decide to cut its dividend to fund investments but they help identify companies likely to continue paying their dividends.

The good news is that most major Australian companies genuinely want to sustain their dividends and manage their capital with this in mind. If you own a diversified portfolio of shares, you should also find that your overall level of dividend income has been rising (most companies have been growing their dividends) which will help to ease the pain of those companies that don't live up to expectations.

Deciding whether to dump an investment is a tougher call. Questions about future dividends and profits are a clear signal to review your position. But often a company won't cut its dividend unless its profits are under severe pressure by which time, its share price has often taken a beating.

Singh says long-term investors should consider selling if they feel there has been a fundamental change that will affect the company's prospects in the medium to longer term. In other words, the question to ask isn't ``Am I disappointed now?", but ``How long am I likely to be disappointed going forward?"


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