Guest Post: Investing Lessons [Advanced]
Sustainability of Dividends
Kelvin Seetoh, a full-time investor with a portfolio of listed businesses in the Asia-Pacific and USA region. His preference for businesses is founder-led, low working capital needs, large addressable market and competent management with integrity. He runs a blog at www.Kelvestor.com.
1 June 2018
Editor note: I would like to warmly welcome Kelvin for his first blog post at Re-ThinkWealth blog. He mostly invests in US and HK based stocks but of course, his technique would be applicable to most stocks in any stock market in the world. I like his writing style and our thinking and methodology are similar in many ways, so I am definitely looking forward to more blog posts from him.
With our banks interest rate and Singapore Government bonds yielding less than 3%, there are investors sought out for higher returns in listed businesses offering a higher yield. Using InvestmentMoats’ Dividend Screener tool, you will see a whole lot of companies offering reasonable amount of yield (4-9%). For example, Starhub (telco) has a yield of approx. 7-8%%, while VICOM (car inspection centre) has a yield of approx. 6%. For most retirees, they would love to park their assets into such dividend paying company to yield them a sustainable income stream to support their expenditures. It would be important to know whether the dividends are sustainable. Any retiree who projected their dividend yield to 6% do not want to wake up to a rude shock of a company cutting its dividends, thereby reducing the effective dividend yield to a much lower percentage. Even for my group of investors, most of them would not enjoy seeing a dividend cut or discontinuation of dividends.
A high dividend yield company may have seemed attractive, but we will explore the sustainability of it together. Here are some ways to determine sustainability:
- Consistency and pay-out ratio
- Availability of free cash flow
I use this website called Dividends.sg as a quick gauge. Looking at Starhub’s dividends, it had been consistent from 2010 to 2016. However, in 2017, the quarterly dividends were cut from 5 cents to 4 cents – a 20% reduction. We will find out why later.
(screen grab from Dividends.sg on 26 May 2018)
Even for a seeming stable business such as Singpost, the dividends are not stable. You can see its quarterly dividends had been reduced over the years.
(screen grab from Dividends.sg on 26 May 2018)
So, what can we rely on?
First, we must understand that business conditions are dynamic. Occasionally, different cycles will cause earnings to fluctuate up or down and it affects the business’ ability to pay out dividends. As investor, we must never have the expectations for dividends to remain the same forever.
Second, create a buffer for your dividends expectations. If an investor needs 4% dividend yield for his lifestyle, then perhaps, it would be conservative to find companies with at least 6% dividend yield and a reasonable pay-out ratio (below 80%). In tough times, companies may cut their dividends, but you are still fine.
For simplicity, we will use the pay-out ratio to determine the sustainability of it. The pay-out ratio formula is dividends per share divided by earnings per share. We are trying to understand how much portion of the company’s earnings are used to pay dividends.
Using VICOM as an example:
|Dividends Per Share (cents)||22.5||27||28.5||26.5||36|
|Earnings Per Share (cents)||32.17||34.04||35.45||31.77||29.90|
You will notice the dividend declared for FY2017 was 120.4% of its earnings per share which may not be sustainable. A historical pay-out ratio of 80% seems more reasonable.
If I am seeking for 5% yield from VICOM, here is how I would compute it. Taking the FY2017 earnings per share of $0.299, multiply it by 80%, the estimated dividends per share is $0.2392. If the required yield is 5%, so we will take $0.2392 dividend by 0.05 or 5%, which gives us the share price of $4.78. But if I am seeking for 4% yield, I will take $0.2392 divide by 0.04 or 4%, which gives us a target share price of $5.98.
An extra note is as of FY2017, VICOM’s balance sheet has a cash per share of $1.21 which allows VICOM continue paying 3 to 4 years of dividends even when there are no revenues. This is a very strong sign of balance sheet strength and dividend paying abilities.
Using Starhub as another example:
|Dividends Per Share (cents)||20||20||20||20||17|
|Earnings Per Share (cents)||22.0||21.4||21.4||19.7||14.1|
Since 2013, You could see that Starhub is very close to paying 100% of its earnings out as dividends. It is increasingly being stretched to beyond 100% in both FY2016 and FY2017. In fact, you will see that Starhub has a net debt per share of $0.36 which is not a good sign for a dividend paying company.
Let us assume that $0.16 is the new norm for Starhub’s yearly dividend yield. Taking $0.16 dividend by $2.08 (26 May 2018 price), an investor would get a yield of 7.7%. It is way more than VICOM’s. However, we must be conservative where we question ourselves: is $0.16 dividends sustainable at all? Just imagine if it is being cut down further to $0.12 per year? The new yield would be 5.7% instead.
Let us look at the recent results of both companies:
For Starhub, the net profit after tax dropped by 13%. It will weaken the company’s ability to pay dividends.
For VICOM, nothing fanciful but the profit grew by 2.5%.
Given a choice, I would stick to VICOM business because the business is more stable and cash rich. I assure myself of the likelihood that the dividends are sustainable.
Availability of Free Cash Flow
The net profit after tax earnings are known as accounting earnings. Under a transaction where I sell 100kg of Apple to Wal-Mart, it is unlikely that I will receive cash-on-delivery as they would likely take some days to pay me. In my income statement, I could book in my accounting profits. However, under cash flow, there is no cash flow for the month. Therefore, we must focus on the cash flow. Likewise, we must know that dividends are paid out of free cash flow (FCF). FCF allows a company to (1) pay down debt (2) buy-back shares (3) reinvest in operations or (4) perform strategic M&A activities.
Free cash flow (FCF) is simply “cash flow from operations MINUS capex”
For FY2017 ended, Starhub generated S$ 517.2mil of cash flows. Deducting S$295.9mil of capex, S$221.3m of free cash flow is available. However, as we look lower, we realised that the dividends paid was 293.9mil. There was a shortfall of S$72.9mil. How did Starhub managed to pay the extra dividend? They took issued perpetual capital securities of S$199.6mil to meet the shortfall.
It tells me that the dividends are not sustainable because it is funded by debt. If a business borrows debt to pay dividends, it is not a good sign. The ideal scenario is where a business pays dividends out of organic cash flows.
When an investor chase for the yield without consideration about the sustainability of dividends, he/she might suffer from capital losses. Despite receiving the yield, the capital losses will cause net losses for the shareholder. While providing a good yield of 5-7%, Starhub’s share price corrected almost 25% since the start of 2018. Focus on sustainable pay-out ratio, stable businesses, and availability of free cash flow.
VICOM’s EPS and DPS historical record: http://infopub.sgx.com/FileOpen/VICOM%20-%20Annual%20Report%202017.ashx?App=Announcement&FileID=494908
Starhub’s EPS historical record: http://ir.starhub.com/investors/?page=Financial-Highlights
Starhub’s FY2017 diluted EPS: http://infopub.sgx.com/FileOpen/StarHubLtdAnnualReport2017.ashx?App=Announcement&FileID=495895
Starhub’s dividend record: https://www.dividends.sg/view/CC3
Starhub 1Q results: http://infopub.sgx.com/FileOpen/PS1Q2018.ashx?App=Announcement&FileID=502951
VICOM 1Q results: http://infopub.sgx.com/FileOpen/VICOM_1Q2018.ashx?App=Announcement&FileID=504648
Quick Summary: VIM Club is a Singapore startup I founded with the aim to be the ultimate value investing course in Singapore — and globally. The approach is using exclusive one to one educational lessons […] Who is it for? Complete beginners in stock investing […]read more
Having multiple streams of income is important in my life. In stock investments, most investors I know get their streams of passive income from capital gains and dividends. Getting premiums/cash flow through selling options is another strategy I often use. But all the serious investors will tell you […]read more
Warren Buffett said that The Intelligent Investor is the best book ever written on investing. This book contains over 600 pages of wisdom. The wisdom that serves as the building blocks for all value investors. This is The Intelligent Investor Summary. Enjoy! Warren Buffett […]read more
The quality of our thinking creates the quality of our life. If the above sentence is true, then Charlie Munger must have made plenty of high-quality decisions over the course of his lifetime. Charlie is currently worth about US$1.8 Billion. He is the right-hand man of Warren Buffett who […]read more
If you are an investor of stocks, you would know that currently (as of November 2018), we are in a (or nearing) stock market correction/bear territory. Before things get worse, here are 5 intelligent things to do during any stock market crash. Here is your playbook for successful investing:read more
This list summarizes 100+ of the best investing quotes (and most intelligent) of all time. They are spoken from some of the best value investing minds in the industry that I have modeled after for my investing philosophy. Both that have passed away (Benjamin Graham) and those that are […]read more
Daniel Ek has built a great business with Spotify. Now that it has recently IPO-ed in 2018, is this digital music streaming service of his, invest-worthy? I am sure that by now you would most likely have heard of Spotify before. But I am sure that not many of you know that Spotify was founded and […]read more
But over time, I would like to invest in good businesses at a fair price instead of continuing to invest in an OK business at a cheap price. Due to Facebook’s recent drop in its share price, I took a stake in Facebook during the past few months and right now, it consists of about a quarter of my portfolio.read more
Circle of competence is one of the key concepts that value investors apply to make money from the stock market. Warren Buffett often talks about the circle of competence concept but not many understood it. In this article […]read more
I have made a lot of mistakes in my life. I have been conned, cheated and have lost money in business deals and investments. Today is my birthday so I thought it would be good to summarize the important lessons I have learned so far about […]read more
Return on Invested Capital is an important formula we should look at when analyzing stocks. ROIC, in short, focuses on analyzing the profitability of a company. What is the formula for ROIC?
Return on invested capital […]
My take on SIA Retail Bond 2019 where I discussed the pros, cons and overall, my thoughts on it. And whether I would invest in it or not. A few good things to say about it, and some things I thought that people should at least be informed on. Instead of using […]read more