From http://www.sharesinv.com/articles/2010/03/12/dividends-pay/
Dividends matter and they matter a lot! Had you bought Singapore Post at the start of 2005 and held it till the end of February this year, inclusive of dividends, it would have compounded at 9.4% over the 5 odd years, against the Straits Times Index’s 5.6%.
During that time frame, Singapore Post’s management had been very generous, rewarding a total $0.357 per share to its shareholders. Stripped of those distributions, Singapore Post would have lagged the market badly, compounding at only a paltry 3.4%.
This is not a case of cherry picking. In fact, a recent Citi Investment Research report noted that in the past 10 years, equities in Asia ex-Japan have generated a compounded total return of 5.9% per annum in US dollar terms, 46% of which came from dividends.
Dividend Matters
Some formulae are in order before proceeding further. Dividend yield, the most basic metric, is calculated by dividing total dividend per share paid out during a full financial year over the stock’s current market price.
Dividend payout ratio (DPR) is more instructive as yield tends to fluctuate depending on the time of the day. This is calculated by dividing total dividend per share paid out during a full financial year over that respective year’s earnings per share (EPS).
Singapore Post, for example, paid out a total of 6.25 cents in dividends per share, when EPS was 7.7 cents in FY09. Be sure to exclude special dividends as they are one-off. Dividend payout ratio works out to about 0.8, which means 80% of FY09 profits were returned to shareholders. The importance of the dividend payout ratio will be elaborated later.
There are companies, particularly those of blue chip pedigree, that have a formal dividend policy stating the percentage of operating or net profit to be paid out. This can be found under the CEO/Chairman’s statement section of the annual report.
Even though a dividend policy is a legally binding commitment, companies that have one loathe changing it, as a downward revision or omission of dividends generally signals financial woes.
Finding Dividend Plays
To be able to consistently return profits to shareholders requires disciplined management as well as strong cash flow on the company’s side. These companies tend to be larger and/or more mature and are found mainly in the banking and finance, consumer staples, utilities and energy sectors.
Those that do have consistent and high dividend payout ratios – so called dividend plays – are likely past their growth phase. The stability in their earnings is generally accompanied by lower levels of R&D and capital expenditures. This is where we return to the dividend payout ratio.
Take the company’s return-on-equity (ROE) and multiply it by the earnings retention rate, which is one less the dividend payout ratio, and you will get the sustainable growth rate (SGR).
Again using Singapore Post as an example, based on FY09’s ROE of 59.2% and earnings retention rate of 18.8%, its sustainable growth rate works out to around 11.1%.
The sustainable growth rate is helpful in gauging whether a company’s growth plan is realistic based on its profits but it will not tell you whether a company has the opportunity to grow.
In this instance, if the opportunity exists and should Singapore Post want to grow its FY09 earnings by more than 11%, it would have to increase its net profit margins (this increases ROE) or fund future investments with debt or the issuance of new stock.
Books To Read
Modestly named “The Ultimate Dividend Playbook” by Josh Peters and “The Future for Investors” by Jeremy Siegel are great books to read for ideas and strategies on investing in dividend plays.
Peters’ book is very comprehensive and provides a detailed explanation on how to select and formulate a portfolio comprising of dividend plays, and the underlying mechanics. Be forewarned “The Ultimate Dividend Playbook” might be too textbook-ish for some and that it is focused mainly on American companies.
Siegel’s more readable account is a must-read for investors worried about the how the impending demographic age wave in developed world would impact future asset returns. While repeating his argument that common stocks are the best asset class in the long run, he highlights the importance of dividends and stock valuations as well as including international stocks in your portfolio.
For non-bookworms, the table below lists a few companies with a history of consistent dividend payments as well as relatively high yields. As usual, more research on the reader’s part should be done before investing.
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