Dividend Investing (Part One)

After reading “The Little Book of Big Dividends,” the key takeaways are:

1)    Yield should be the last consideration

2)    Consistency of dividend payment is great, but you should be concern with the sustainability of the dividend payments.

3)    The ideal, dream company is one with the possibly of growing dividends. This is tough for a slow-grower (think blue chips!).

4)    Since REITs are paying out 90-100% of its cash flow, it is not recommended despite its high yield.

5)    Dividends are paid with cash

So what follows are my inputs to this wonderful book.

Safety of Dividends

A commonly used metric is known as “Dividend Payout,” and the steps to calculate it is simple:

a)    Get the value of total dividend pay out in cash

b)    Divide this value by net income.

c)     Express this value as a percentage, to get dividend payout.

There is a bit of problem here... earnings, reported in the income statement, are not cash transactions.

Some food for thought:

Expenditures are not expensed immediately in the income statement. If you were to buy a $4000 computer for your small business, it will turn up in the Cash Flow statement as a $4000 deduction.

However, depending on how your depreciate your computer, which is a management decision, you may choose to expense this $4000 over 10 years. So instead of a $4000 deduction in your income statement, you see a $400 deduction yearly, for ten years, in your income statement instead.

This is usually not a problem unless management is deliberately deceiving shareholders. Imagine a computer being expense over 20 years!

Trade Receivables are sums of money that customers owe to the company, and in the most unfortunate circumstances, they can become bad debt should these customers become insolvent and written off. But these sums are still considered as transactions in the income statement...

The cost of mergers and acquisitions does not show up in an income statement. Likewise, cash used in the purchase of companies, only shows up in the cashflow statement. The income statement will only show the profits declared from these newly acquired subsidiaries, but the it will show up under “Cashflow from investing activities.” Plenty of unethical managements had used M&A to shore up bottom lines, paying obscene premium for goodwill; but an honest management should adopt sound acquisitions.

(I think Singpaore Post’s M&A over the years make a good study on whether investors can tell if M&A is beneficial. Coincidentally, Singpost is well regarded as a solid dividend payer in the past!)

Over long term, cash flow should move in line with the income statement. Hence, if a company consistently pays above 70% of its earnings as dividends, one should really check its FCF.

The next article, I will attempt to dissect a blue chip company as a dividend payer. The idea of blue chip as a safe dividend payer is widespread, hence it will be interesting to see if this is so.