I guess it?s only right that there are many investors out there who value their dividends. After all, it represents a true source of passive income stretching many years into future, provided the homework was done right when selecting the share.
And for that, there?s something that isn?t right. You see, the focus for many investors on the ability of a company to maintain or even increase its dividends is on its earnings. The more earnings grow, the more dividends a company can pay, or so the theory the goes.
I guess it’s only right that there are many investors out there who value their dividends. After all, it represents a true source of passive income stretching many years into future, provided the homework was done right when selecting the share.
And for that, there’s something that isn’t right. You see, the focus for many investors on the ability of a company to maintain or even increase its dividends is on its earnings. The more earnings grow, the more dividends a company can pay, or so the theory the goes.
But that’s where we need a reality-check. In actual fact, dividends are paid out through cash, not through earnings. And that is why focusing on a company’s free cash flow can help us determine if a dividend is sustainable.
To obtain free cash flow, look out for the cash flow from operations reported by a company annually, and then subtract capital expenditures (sometimes also known as “Purchase of property, plant, and equipment” or other similar sounding names) from it.
The next step – and the key step – would be to compare free cash flow and the actual cash dividends paid out each year. If the former is consistently higher than the latter over a good number of years, it’s a good sign that the company generates enough actual cash to maintain those dividends.
Here are four names that do meet the criteria going back to their last five completed financial years: Vicom (SGX: V01), ARA Asset Management (SGX: D1R), Raffles Medical Group (SGX: R01), and Dairy Farm International Holdings (SGX: D01).
|Company||Total free cash flow for past five completed financial years||Total cash dividends paid for past five completed financial years|
Source: S&P Capital IQ
That consistency in their free cash flows and the apparent reliability of their dividends is also likely to be a strong factor in their market-beating performance over the past five-plus years since the start of 2008.
|Company||1 Jan 2008*||6 Dec 2013||% Change|
|Straits Times Index (SGX: ^STI)||3,482||3,114||-10.5%|
|*Except for the Straits Times Index, prices on 1 Jan 2008 are adjusted for cash dividends, stock splits, rights offerings, and spin-offs|
Source: S&P Capital IQ
Foolish Bottom Line
While it’s important to take a hard look at the correct numbers to look out for signs of a company’s ability to maintain their dividends – with market beating performance and growing dividends as a potential reward – it’s even more important to understand that the numbers are just a beacon that signals that a particular share is worthwhile researching further.
It’s crucial that investors take the time to study the qualitative aspects of each business to determine if it’s likely that the ‘special sauce’ that allowed them to churn out the cash in the past will still be present in the future.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares of Raffles Medical Group.