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.