Annette Sampson

It’s the total return from shares that matters, not just the dividend

IS THAT LIKELY?

Finance 101 is clear cut. Dividends are simply a means through which companies distribute their profits back to their owners. So if a company you own shares in is struggling to maintain its profit or, heaven forbid, losing money, its ability to pay out dividends is reduced.

In February, Telstra cut its interim dividend to 11 cents, from 15.5c the previous year, after a five-year fall in half-year profits. But here’s the thing: that dividend cut was larger in percentage terms than the profit fall because Telstra also decided to change its dividend policy. For years it had paid most of its profit in dividends. Now it is paying out 70% to 90% and keeping a reserve to reinvest in the company, particularly taking the battle to its competitors.

This is where it becomes more complex. While falling earnings can be a warning sign that slower dividend growth or a dividend cut lies ahead, it is not the only factor to take into account.

DIVIDEND PAYOUT RATIOS

If you are looking for income from your investments, a key consideration is a company’s dividend payout ratio. This is the proportion of its profits that it pays out in dividends. Thanks to the tax benefits of dividend imputation, Australian investors have something of a love affair with dividends, and companies are more inclined to fund high dividends to keep their shareholders happy.

This means our payout ratio is typically much higher than in many other markets. In the US, for example, where investors are more focused on share price growth, a payout ratio of 50% is regarded as normal. While figures differ between companies and industries, many Australian companies pay out 70% to 80% or more.

So why does this matter? First, if a company is only paying out 50% of its earnings in dividends, it has more room to dip into reserves to maintain its dividend if earnings were to take a hit. By contrast, a company with a high payout ratio doesn’t have that sort of wiggle room. Companies with very high payout ratios, such as Telstra until recently, could be forced to borrow to maintain dividends during a bad period – clearly not a sustainable strategy.

There is also an argument that companies paying out most of their earnings to shareholders are doing so at the expense of reinvesting to grow the business. Obviously, a more mature company will have less need to reinvest than one that is growing quickly, but some analysts see high payout ratios as an admission that management is not focused on future growth, and so is less likely to reward shareholders with capital gains.

While a solid dividend income can feel reassuring, it is the total return from shares that matters. If a steady dividend is more than offset by a falling share price, you’re still losing money.

WHEN CUTS HAPPEN

When Telstra cut its dividend, the market sent a strong message of disapproval via an immediate 10% share price fall. But dividend cuts are by no means rare events. In the wake of the GFC, the banks – the darlings of dividend investors – trimmed their dividends to rebuild their financial reserves. Both Rio and BHP were forced to cut dividends as the commodities boom came to an end. In the first week of this profit season, leading stocks such as AMP and Tabcorp also announced lower dividends.

Some analysts had been talking up the risk of further dividend cuts by the banks as a result of the royal commission, though at the time of writing only CBA had reported its results. Despite a drop in annual cash profit, CBA announced a small dividend rise.

WARNING SIGNS

For investors, the key question is not whether a stock has a good dividend yield but whether it has the ability to sustain and grow that dividend. Signs of an unsustainable dividend include a high payout ratio, a declining earnings outlook (especially if it indicates a downward trend rather than just a short-term blip), and changes in company priorities – such as a board that is becoming more focused on investment.

* The author owns shares in CBA and NAB.

Annette Sampson has written extensively on personal finance. She was personal finance editor with The Sydney Morning Herald,a former editor of the Herald’s Money section and a columnist for The Age. She has written several books.