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Sustainable Dividends:

This article originally appeared on The DIV-Net on February 15th, 2009.

Last week I wrote a post titled Leveraging Dividends where I provided tips for using conservative leverage in a dividend growth portfolio. This week I want to expand on what I deem to be conservative income for any investor looking for companies that pay dividends.

There have been a number of dividend cuts announced over the past 12 months and many investors are speculating on who could be next or how far further dividend cuts could go. As a dividend investor you have to develop a discipline that prevents you from chasing yield and allows you to look at the operations of the company with an unbiased view. There are a number of public corporations whose operations aren’t sustainable and neither is their dividend.

How does an investor identify what is a sustainable dividend?

You need to look at the operations of the business, examine the business model, assess their earnings strength and determine the payout ratio of the company.

Yield isn’t the sole factor that should set off alarm bells in the minds of investors; the payout ratio is more important. The payout ratio is the amount of earnings that are paid out as dividends to investors; the higher the payout the less sustainable a dividend potentially becomes.

For a company with high growth and a capital intensive business the payout should be relatively low; below 50%. The reason for this is because the company needs to re-invest earnings back into the business in order to continue growing and maintaining their strong financial position. For a company with low growth and limited capital requirements the payout can be slightly higher; above 50%. The reason for this is because the company can afford to pay out more in dividends to investors since its operations don’t require the majority of earnings to be re-invested back into the business. A company always needs to retain some portion of earnings, but determining what is appropriate depends on the business model and life-cycle of the business.

Many investors have chased yield over the past year and been burnt badly when the company’s dividend has been subsequently slashed.

What companies have sustainable dividends?

I’ve included a list of 25 companies whose payout ratios range from a low of 14.4% to a high of 66.5%. They include companies from different industries, with different business models and different demands for re-investment of their earnings.

I consider each to have sustainable dividends and each should have the ability to endure this difficult economic period with their dividends intact or higher. They aren’t the most exciting companies, but they provide something that many investors lack in their portfolios at this time: consistency & sustainability.

Disclosure: I own shares in BAX, BDX, KO, CL, GIS, SJM, JNJ, KMB, PG, SNY, WMT, CNR, ACO.X, ENB (via ENB.PR.A), FTS, RCI.B, SJR.B & X.
 

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{ 3 comments… add one }
  • Richard F. March 1, 2009, 8:58 am

    Great article! Some sites don’t seem to list the payout ratio. Correct me if I’m wrong, but you can calulate this as:

    Payout Ratio = (Annual Dividend Per Share / Earns Per Share)*100

    I was considering buying shares in Yellow Pages YLO.UN due to the high yield (20-25%). With a payout ratio of 85%, I suspect the dividend will eventually get slashed.

    Thanks for the useful atricle,
    Richard.
    http://72rule.blogspot.com

  • Nurseb911 March 1, 2009, 9:14 am

    Thanks for the feedback Richard,

    The payout ratio is the percentage of earnings paid out as the dividend: [Dividend/EPS]*100

    For income trusts high payouts are reflective of their business model. They payout the majority of their cashflow each month to unit holders. Many trusts can sustain their distributions above a 90% payout ratio because they are distributing cash instead of earnings. Carefully examine the cashflow statement of the company (YLO.UN) to determine if the trust has a enough monthly cashflow to cover expenses and the distribution. For a public corporation distributing a dividend 85% is likely not sustainable.

    Best of luck on your blog. The Rule of 72 is a great concept I’ve written about on my site before and the wonder of compound interest is something many investors overlook as long-term investors.

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