Div­i­dend cover

Finweek English Edition - - INVESTMENT -

We’ve writ­ten a lot about div idends over t he years as I con­sider them to not only be one of the most im­por­tant parts of in­vest­ing but also one of the most ne­glected. Div­i­dend re­turns tend to get lost be­cause we look at the per­cent­age re­turn a share has de­liv­ered since we bought it, but that doesn’t in­clude the div­i­dends we’ve re­ceived. Fur­ther, that first div­i­dend pay­ment is typ­i­cally re­ally small but as I’ve con­sis­tently men­tioned, it grows with time and can quickly be­come re­ally sig­nif­i­cant and gives us great cash f low with­out hav­ing to sell.

This week I want to go back to a com­ment I made about Kumba Iron Ore a few weeks back, just af­ter its trad­ing up­date. The com­pany had told us earn­ings would be lower, and I pre­dicted a div­i­dend of around 1 700c/share. In­stead, the div­i­dend came in at 1 561c/share. So what went wrong with my pre­dic­tion?

When I pre­dicted a 1 700c div­i­dend, I said that was as­sum­ing Kumba kept the div­i­dend cover at 1.2 times. If it had, then it would have paid 1 691c, close enough to my call. But in re­al­ity, the miner moved the div­i­dend cover to 1.3 times and paid out the more mod­est 1 561c.

So what is this tricky lit­tle div­i­dend cover? It is sim­ply the num­ber of times prof­its cover the div­i­dend. So in the case of a 1.2 times div­i­dend cover, it means that for ev­ery 120c of profit the com­pany pays out 100c. If the div­i­dend cover was three times, then for ev­ery 300c profit Kumba would pay out 100c in div­i­dends. It is lit­er­ally the num­ber of times prof­its cover div­i­dends. As a rule we use the head­line earn­ings per share as the profit num­ber, as div­i­dends are paid per share.

If we step back: a com­pany makes a profit and it is then up to the board of di­rec­tors (those peo­ple who run the com­pany on our be­half) to de­cide how much of the profit to keep in the com­pany and how much to give to share­hold­ers. That ra­tio will de­pend on two main points. Firstly, how much cash the com­pany needs in order to grow and im­prove prof­its, and what the ex­pec­ta­tion of the share­hold­ers is.

In the case of Kumba, the miner made another juicy profit than in the pre­vi­ous pe­riod. But the com­pany still has capex ex­penses and those ex­penses are not go­ing down. So when prof­its dipped, it ei­ther had to cut the capex bud­get or the div­i­dend and it chose the lat­ter by slightly in­creas­ing the div­i­dend cover and hence de­creas­ing the div­i­dend.

A smaller, fast-grow­ing com­pany may elect to pay no div­i­dend and rather keep the money to grow the busi­ness. If share­hold­ers trust the board to use the money wisely to grow the busi­ness, they’ll be per­fectly happy with that. Then, as the com­pany grows and prof­its grow, they can start pay­ing a div­i­dend.

One risk is too high a div­i­dend, in other words the com­pany doesn’t keep enough prof­its to grow the busi­ness. This is one of the com­plaints against Pick n Pay and one of the rea­sons why the re­tailer lost its way. Grow­ing a busi­ness, even a large, ma­ture busi­ness, costs money and com­pa­nies need to keep some prof­its back to fund that growth. If they pay too much out in div­i­dends, then fu­ture growth will suf­fer.

As in­vestors we need to re­mem­ber div­i­dends as they form an im­por­tant part of the fu­ture prof­its from a share, but we must also mon­i­tor the div­i­dend cover to see whether the com­pany is in­creas­ing or de­creas­ing the ra­tio it pays to share­hold­ers. Any large capex spend will gen­er­ally re­sult in a higher div­i­dend cover and a lower div­i­dend pay­out.

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