Who doesn’t love dividends? Dividends are a form of passive income to supplement our pay cheques or even sustain our lifestyle. Not all dividends are made equal, though. A company’s dividend yield doesn’t tell us anything about its sustainability. In fact, a company with a lower dividend yield might sometimes be a better dividend share than a company with a higher yield.
With that, here are my three top tips for picking the best dividend shares.
1. Earnings and free-cash-flow growth
Firstly, dividend companies should exhibit stable growth in both earnings and free cash flow. Earnings or net profit are what is left from sales after a company pays off all of its expenses.
On the other hand, free cash flow is what a company generates after deducting cash for its operations and capital expenditures. A company’s free cash flow shows how much money it has available to pay out dividends to shareholders, or strengthen its balance sheet, among other things.
A company with consistently growing earnings and free cash flow likely has a strong business, and that’s what investors want. Such a company would also be inclined to pay out higher dividends as its business grows over time. On the other hand, a company with falling earnings and free cash flow would be pressured to cut dividends or, worse still, stop paying dividends entirely in order to sustain its business.
2. Dividend payout ratio
The dividend payout ratio tells investors what percentage of a company’s earnings or free cash flow are paid out yearly as a dividend. I prefer companies that pay out less than 80% of their free cash flow as dividends, because that leaves space for dividend growth in the future if free cash flow were to stay stagnant.
On the other hand, companies that pay out more than 100% of their earnings or free cash flow as dividends have to cut dividends to bring them down to more sustainable levels.
3. Balance-sheet strength
The balance sheet reveals the financial strength of a business. Companies with lots of cash and little or no debt have the financial muscle to navigate through any tough business conditions. Such companies also have the leeway to pay out higher dividends instead of worrying about paying off their debt.
As I mentioned earlier, free cash flow can be used to pay dividends or pay off debt. If a company doesn’t have debt to grapple with, it can focus on things that matter, such as keeping shareholders happy with higher dividends or reinvesting into its business to further growth.
Stringing everything together
Let’s use Straco Corporation Ltd (SGX: S85), owner of tourism attractions in Singapore and China, to illustrate the points discussed above. Straco has exhibited the following traits:
1. Earnings growth of 23.3% per annum, from S$3.4 million in 2006 to S$41.8 million in 2018.
2. Free cash flow growth of 54% per year, from S$5.5 million in 2006 to S$47.2 million in 2018.
3. 2018 dividend payout ratio of 72% (in terms of earnings) or 64% (in terms of free cash flow), including the special dividend per share of S$0.01 dished out for the year.
4. Cash balance of S$209.8 million with just S$34.9 million in total debt, as of 31 March 2019 (Straco had more cash than debt from 2006 to 2018).
With that, Straco had grown its dividend payout from 0.25 Singapore cents per share in 2006 to 3.5 Singapore cents in 2018, translating to phenomenal growth of 25% per year.
Source: Straco 2018 AGM presentation
The tourism company has been able to grow its dividend strongly in the last 12 years due to its 1) strong earnings and free-cash-flow growth; 2) conservative dividend payout ratio; and 3) extremely healthy balance sheet that has never been in a net debt position. As long as Straco can maintain these three “secret” ingredients, it can continue its trajectory as a cash-rich company that continually pays out higher dividends over the long term.
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The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. The Motley Fool Singapore has recommended shares of Straco Corporation Limited. Motley Fool Singapore contributor Sudhan P owns shares in Straco Corporation Limited.