This article goes back to basics and outlines why a consistent record of well-covered dividend payments is the first thing I look for in a company.
Table of Contents
- A brief introduction to dividends
- Dividends support efficient capital allocation
- Dividends create commitment and accountability
- Dividends are a helpful yardstick
- Dividends provide investors with a regular income from their investments
- Looking for a long record of continuous dividend payments
- Getting your hands on ten years of financial data
- Reviewing Ted Baker’s dividend
- Looking for consistently covered dividends
- Calculating dividend cover
- Consistent dividend cover at Burberry (BRBY)
A brief introduction to dividends
Dividends make up the backbone of my investment strategy, so the first thing I look for in a company is a track record of consistent and sustainable dividends.
If you’re new to investing, here’s a quick definition:
Definition
Dividend per share (DPS): Dividends are cash payments made from a company to its shareholders. In theory, cash should be paid out to shareholders as a dividend when the company cannot invest that cash within the business at an attractive rate of return.
There are several reasons why dividends are central to my approach. The most important reasons are:
Dividends support efficient capital allocation
A company should only retain cash generated from operations if that cash can be used to produce an attractive return. The main uses of retained cash are:
- Maintaining the existing business
- Organically growing the business (e.g. buying stock or investing in factories, stores or equipment)
- Acquiring other companies
- Paying down debt
- Buying back shares
When those options are exhausted, cash should be returned to shareholders as a dividend.
With companies that don’t pay a dividend there is, in my opinion, a greater risk that cash retained within the business will be used to expand the CEO’s empire (and pay packet) rather than maximise returns for shareholders.
Dividends create commitment and accountability
Companies with progressive dividend policies have made a promise to investors that they will maintain or grow the dividend each year.
This provides a public and very concrete goal for management to achieve. Of course this promise can be broken, but on average dividend-paying companies have historically performed better than non-dividend payers.
Dividends are a helpful yardstick
A progressive dividend gives investors a gauge for the long-term progress of a company. While earnings (and to a lesser extent revenues) bounce around from year to year, a progressive dividend can act as a more stable indicator of a company’s underlying growth rate.
Dividends provide investors with a regular income from their investments
Perhaps the most obvious benefit of dividends is that they’re a form of cash income. For investors who want an income from their investments, dividends are an excellent way to receive that income without having to sell any shares.
This removes any confusion around what is or isn’t a sustainable withdrawal rate, because withdrawing dividends should always be sustainable.
Dividends also provide an always-positive return which is independent of a company’s share price. This can help reduce the volatility of your portfolio and provide a positive return even if (heaven forbid) one of your holdings eventually goes bust.
Looking for a long record of continuous dividend payments
Benjamin Graham, the father of value investing, once said that “Each company should have a long record of continuous dividend payments.” The logic behind this rule is simple:
If investors want to buy companies that are likely to pay a consistent dividend in the future, the best place to find such companies is among those that have paid a consistent dividend in the past.
This leads to the first of many rules of thumb which I use to guide my investment decisions:
Rule of thumb for consistent dividends
Only invest in a company if it paid a dividend in every one of the last ten years.
Most companies pay dividends multiple times per year, so if a company missed a single interim or final dividend then that may be okay, as long as some sort of dividend was paid every year. However, if no dividend was paid in one or more years then the company goes straight into my metaphorical waste paper bin.
Although I look for a consistent track record of dividend payments, it’s important to remember that dividends are paid at the discretion of the company’s board of directors. Unfortunately, this means you can never be 100% sure that a company won’t cut or suspend its dividend at some point in the future.
The coronavirus pandemic is a good example of this. During the global pandemic, even very defensive companies such as J Sainsbury (a supermarket) or AG Barr (maker of the IRN BRU fizzy drink) suspended their dividends. This doesn’t make them bad companies, it just means sometimes the economic outlook is so bad that suspending the dividend is the sensible thing, no matter how defensive the company.
Having said that, it is possible to invest in companies where the odds of suffering a dividend cut or suspension are relatively low, and the first step in that direction is to look for a track record of consistent dividends over at least the last ten years.
Getting your hands on ten years of financial data
There are various ways to get hold of a company’s financial results for the past ten years. The obvious place to look would be the company’s annual reports, but that approach is very time consuming and any per share data, such as dividends per share, will not have been adjusted for share splits or share consolidations.
Share splits and consolidations change the number of shares a company has and the price of each share, but they don’t affect the value of each shareholder’s holdings. However, they do affect per share figures such as dividends and earnings per share, which means per share figures from older annual and interim results have to be adjusted to take account of the change.
You could correct for splits and consolidations by hand, but my preferred approach is to get ten years of data from data providers such as:
- Morningstar
- SharePad (or ShareScope)
- Sharelockholmes
You can then supplement that as necessary with data from the annual results and reports, which you can find on:
- The company’s website
- annualreports.co.uk
- investegate.co.uk
- beta.companieshouse.gov.uk (including annual reports more than ten years old for when you’re doing a really deep dive on a company)
Now that we have the necessary data, let’s analyse the dividend record of a real company which has been in my portfolio at some point over the last few years.
Reviewing Ted Baker’s dividend
Ted Baker (TED) is a FTSE 250 fashion retailer listed in the defensive Personal Goods sector. It is known for its quirky British-themed style and has around 500 stores across the globe. It sells through three main channels:
- Retail (stores and online)
- Licences (product and geographical)
- Wholesale (e.g. through third party department stores)
Ted had the following dividend record for the ten years to 2019:
| Year | Dividends per share (p) |
|---|---|
| 2010 | 17.15 |
| 2011 | 20.60 |
| 2012 | 23.40 |
| 2013 | 26.60 |
| 2014 | 33.70 |
| 2015 | 40.30 |
| 2016 | 47.80 |
| 2017 | 53.60 |
| 2018 | 60.10 |
| 2019 | 58.60 |
Ted Baker’s dividend record to 2019
Looking for dividend payments in every one of the last ten years is a pretty simple test. Either a company made a dividend payment in every year or it didn’t. In Ted Baker’s case it did, so at this stage of the analysis Ted would still be a viable investment candidate.
Looking for consistently covered dividends
Of course, dividends don’t appear out of thin air. A company must produce profits before it can pay dividends, and those profits will in turn depend on revenues.
To avoid any confusion, here are some more definitions:
Definitions
Revenue – The total amount of money earned by a company during a given period (typically a year) before any expenses are deducted. You’ll find it at the top of a company’s income statement. It’s also known as sales or turnover.
Earnings – The amount left over after all expenses and taxes have been deducted from revenues. Also known as profit after tax or post-tax profit.
Earnings per share (EPS) – Earnings divided by the number of shares. It’s often quoted in pence and is the earnings part of the well-known price to earnings ratio (PE). Also known as reported or basic EPS.
Adjusted EPS – Some companies quote adjusted earnings figures. These remove one-off, non-recurring income and expense items such as income from the sale of a building or redundancy expenses following a plant closure. The idea is to provide a better picture of a company’s core or underlying performance by removing items that are unlikely to recur. Some data providers quote normalised earnings, which is a standardised version of adjusted earnings.
For many years I focused on adjusted EPS in an attempt to get a better view of a company’s underlying performance, without the distracting noise of one-off expenses. However, experience has taught me that adjusted EPS can sometimes paint an overly rosy picture of a company’s past.
This happens when a significant amount of expenses are repeatedly classified as one-offs by management, even when those expenses seem to recur year after year. Sometimes it can even look as if management are trying to make their results look better than they actually are.
To avoid this I now focus on basic or reported earnings per share, which always deducts all expenses. This gives me a better picture of how the overall company is performing, warts and all.
Calculating dividend cover
The calculation for dividend cover is relatively simple:
dividend cover = EPS / DPS
In other words, I want earnings to be greater than the dividend. I’m looking for consistently covered dividends, so my rule of thumb for dividend cover is:
Rule of thumb for dividend cover
Only invest in a company if dividend cover was greater than one in at least five of the last ten years.
Let’s see how this rule of thumb can be applied to another company I’ve owned in the last few years.
Consistent dividend cover at Burberry (BRBY)
Burberry is a FTSE 100 luxury fashion retailer. Like Ted Baker, it’s listed in the defensive Personal Goods sector. Also like Ted Baker, Burberry sells through three channels:
- Retail (over 400 stores globally, plus department store concessions, discount outlets and e-commerce)
- brand licensing (where other companies get to manufacture goods carrying the Burberry name)
- Wholesale (e.g. department stores and other retailers)
Burberry paid a dividend in every one of the last ten years, so it passes my first rule of thumb.
To check its dividend cover for consistency we’ll need the company’s earnings and dividends per share covering ten years, which you can see below.
| Year | EPS (p) | DPS (p) | Dividend cover |
|---|---|---|---|
| 2010 | 34.4 | 14 | 2.46 |
| 2011 | 48.3 | 20 | 2.41 |
| 2012 | 59.3 | 25 | 2.37 |
| 2013 | 57.0 | 29 | 1.97 |
| 2014 | 72.1 | 32 | 2.25 |
| 2015 | 75.1 | 35.2 | 2.13 |
| 2016 | 69.4 | 37 | 1.88 |
| 2017 | 64.9 | 38.9 | 1.67 |
| 2018 | 68.4 | 41.3 | 1.66 |
| 2019 | 81.7 | 42.5 | 1.92 |
Burberry’s dividend cover to 2019
As the table and chart above show, Burberry’s dividend was covered every single year, which means its dividend cover score is ten out of ten. Ten is obviously more than my minimum requirement of five, so Burberry easily meets my standard for dividend cover.
Obviously this is just the first step and there’s a lot more to do before a company can be deemed investable or not, so in the next article in this series I’ll go over how I measure a company’s growth, as growth is of course a key component of long-term returns.
For now though, here’s a quick reminder of my rules of thumb for dividends and dividend cover:
Rules of thumb for dividends and dividend cover
Only invest in a company if it paid a dividend in every one of the last ten years.
Only invest in a company if dividend cover was greater than one in at least five of the last ten years.
If you’d like to try out these rules of thumb, take a look at my investment spreadsheet.
Disclosure: At the time of writing I still held Ted Baker and Burberry. Ted Baker has suffered some high profile problems in recent years and I’ve already learned from and written about what went wrong at Ted Baker.
Hello John,
quite often I have been reading (e.g. at Seeking Alpha) statements like: “Dividends are paid from FCF (free cash flow), not from earnings. Then they also talk about a “payout-ratio” as the ratio between the dividend paid and the FCF. The lower the ratio the less the likelihood of a dividend-cut or worse.
How does this (the statement regarding FCF and dividends) relate to your writing (dividends paid from EPS)? Is it just a different method of analysis or are we using different terminology?
Thank you and kind regards!
Udo
Hi Udo, that’s an excellent point.
From a balance sheet (i.e. accounting) point of view, dividend payments reduce both retained earnings and cash, so both earnings and cash are important. A UK company cannot legally pay out more in dividends than its retained earnings on the balance sheet, so over time earnings should more than cover the dividend. Of course, in a given year earnings may or may not cover the dividend, but on average over the medium and longer-term they should.
As for cash, it’s also true that free cash flows should cover the dividend, at least on average over a number of years. For those who don’t know, free cash flow is the amount of cash generated from operating activities (which can be different from operating profits) minus the cash cost of capital expenses.
This mostly becomes a problem in companies that have lots of expensive capital assets (factories, vehicles, machinery, infrastructure etc) which are being expanded at a rapid rate. For (a simplified) example, a company may earn £100m, have a (non-cash) depreciation expense of £50m but a (cash) capital expense of £150m. In that case, the massive capital investment program (three times greater than depreciation, where depreciation is typically close to the maintenance cost of capital assets) generates a £100m drag on cash flows, leaving the company with zero free cash flow even though its earnings are £100m.
In other words:
earnings = £100m
earnings + depreciation (similar to operating cash flow) = £100m + £50m = £150m
op cash flow – capex = £150m – £150m = £0m
This company could technically pay out a £99m dividend and it would be covered by earnings, but not by free cash flows. If it was paid it would just have to be paid out of any existing cash balance, or funded by debt or the sale of assets and so on.
So yes, free cash flows matter, although I don’t look directly at free cash flows. Instead, I look at depreciation and capital expenses and their size relative to each other and to earnings. This tells me something about the cash drag from capital investment and whether that’s going to be a problem in terms of cash available for the dividend.
I’ll explain more about my thoughts on the impact of depreciation and capex on cash flows in a future post.
Hi John
On a slightly different tack, there’s been a discussion in the media recently about the responsibility of companies to invest more of their earnings in R&D rather than distributing to shareholders. In other words, UK Ltd’s poor record on productivity improvement in recent years is partly the fault in management being too quick to return cash rather than investing for the future benefit of the business and all it’s stakeholders.
Personally, I think the confused accounting approach to R&D (expense or capex?) and lack of tax incentives don’t make it easy for management to take this ‘enlightened’ approach and it’s safer to return cash rather than try to justify R&D investment when it’s not possible to identify the return on investment.
What’s your view. If there was a clearer investment case, would you be prepared to take a lower dividend in return for future benefits?
Regards
Steve
Hi Steve
I’m not sure I buy the argument that companies systemically underinvest in R&D in order to pay out dividends or (even worse according to the media) buy back shares.
I’m sure there are specific cases where that happens, just as there will be specific where companies invest too much in R&D and the expense of dividends. The world isn’t perfect so we shouldn’t expect perfect capital allocation. But I don’t think there’s a systemic problem.
If the incentives are right (and that is by far the most important thing) then in most cases companies (meaning the people in those companies) are smart enough to invest wherever the expected risk-adjusted return exceeds their hurdle rate (10% annualised or whatever). If there aren’t enough projects with those expected returns, cash should be returned to shareholders as a dividend or through buybacks.
In fact I think the opposite problem may be more prevalent, i.e. excessive investment in R&D, capital assets and so on, where the expected returns turn out to be optimistic and actual returns fall short (and in hindsight were always likely to do so).
Personally, I would happily accept a dividend cut if a company found a way to reinvest that cash at a higher rate of return than I could reasonably expect to achieve. So if a company decides it can get an expected 20% annualised return by investing in new technology, a new drug or by building a spaceship or a new bridge, then yes, I would gladly have them reduce my dividend to fund the project because I’m unlikely to get a 20% return by reinvesting the dividend.
As I said earlier, if the incentives are appropriate then I think most companies are capable of allocating capital reasonably rationally at least most of the time.
Hi John,
I think the ability of a company being able to payout a sustainable dividend is dependent on both its balance sheet and I guess the nature of the industry the company operates in and its position within that industry. Often this may give a completely different picture compared to just relying on previous dividend history or other financial data.
For example Imperial Brand/Tobacco until recently had a very generous dividend policy which it increased by 10%. Unfortunately if you dug deep a different narrative emerged:
A Huge debt
Operating in Western markets where volumes were fast declining
Lack of commitment to Reduced Risk Portfolio
This completely contradicts the financial data for Imperial Brand as a going concern, which is why I would advise to not completely rely on financial data to determine whether a dividend is sustainable.
I used to think that a high payout ratio was preferable for a stock but I now realise that it makes more sense to invest in a company which has sufficient opportunities to reinvest within the business and a capable management to do so to generate a higher return. This may mean settling for a stock with lower yield. However as long as the company is debt free (lowish debt) and has a reasonable PE ratio it is likely to yield superior result on a long term basis.
I missed the boat with L’Oréal partly because I was only in University and had no interest investing but between between 2006 and 2020 it was able to grow dividend at 10.5% CAGR but the catch was management had a payout ratio of 57%. Hypothetically speaking if you invested in L’Oréal in 2006 and held the stock thick and thin your capital appreciation would have been 331%.
In addition the company would have returned 34% of your original investment in cash after tax to do as you please. It’s strange how fast my investment approach is evolving whether it will payoff time will tell.
Hi Reg
“I would advise to not completely rely on financial data to determine whether a dividend is sustainable. ”
I completely agree with this, but I still think a reasonable first step (and that’s all this article is) is to look for a track record of consistent dividends and consistent dividend cover.
Concerns about profitability, debt, whether the company’s core market is growing or shrinking and so on are all important, but for me the first step is still to look at the company’s financial track record over at least the last ten years.
Otherwise you can waste a lot of time looking at companies with inconsistent or nonexistent dividend track records, and those are generally not companies I’m interested in so why look at them!
John, will you be making an exception like:
A dividend must be paid in every year except 2020, if the company accepted financial assistance and/or was discouraged by government policy/reguation to suspend the dividend.
Without this exception, what is the reduction in the universe of qualifying stocks? e.g. from 100 stocks to 50 stocks
Will you sell existing positions of companies because they suspend the dividend this year? [I expect that you will not, because you have demonstrated a lot of forgiveness and discretion in the past when choosing positions to close.]
hi Ken, that’s an excellent point. I’m going to see how things pan out. If the investable universe (i.e. stocks that have paid a dividend in 2020 and over the prior decade) shrinks dramatically then I’ll have to create some sort of workaround for 2020, but I don’t want to go down that route unless I really have to.
As for selling holdings because of dividend suspensions this year, the short answer is no, I don’t plan on selling holdings just because of dividend cuts. Normally a dividend suspension is a very bad sign, but that simply isn’t true this year. Even companies like Domino’s Pizza (which I own) that have been well positioned (through luck) for a pandemic have still suspended their dividend just to be on the safe side.
So any sales I make will be made on a more considered basis, although any dividend suspension or cut will still be a factor.
John, thank you for discussing the temporary nature of dividend suspension and the effect on the ‘model’.
Using 10 years of historical reports has the benefit that one year of poor fundamentals is like a speed bump – when you unexpectedly hit it at 40mph it is unpleasant and you hear an awful metal scraping noise and you slow down but you stay on course and don’t crash and the journey continues.
But how can we compare a stock, today, that is badly affected with another stock that fares better?
Let’s say that Burberry sales are down 80% and the share price is down %30. Let’s say that Dominos sales and share price are unchanged.
In the spreadsheet we have financial data up to 2019 but we have today’s market price per share. Therefore, the ranking of Burberry is better than Dominos. We have to wait one year before we get 2020 financial statements. Until then, how do we reduce the attractiveness of Burberry in a fair way?
I am currently dealing with this problem by not buying any stock that has a forecast of lower sales. This is a safety precaution that eliminates companies that are genuine bargains along with companies that might go bankrupt (perhaps airlines or travel agents).
How can we adjust the model to be more nuanced and take advantage of opportunities?
As a general rule I try to think about where a company might be in five or ten years.
I think the main risk from this pandemic is that a company will not be around in five or ten years, so at the moment the most important thing is some combination of sales resilience in this environment and a strong balance sheet.
In Burberry’s case, for a retailer it has small lease obligations relative to its earnings and little debt, although it has now loaded up on debt to provide sufficient cash to see it through this crisis. Its wholesale and retail businesses are obviously very exposed to lockdowns, but at least it has a mature online business.
Layered on top of all that is the huge amount of uncertainty around how long this pandemic will last, how bad it will get and how quickly the economy will recover.
My guess (and that’s all it can realistically be) is that Burberry won’t go bust, given its relatively strong balance sheet, ability to generate some sales online and very strong brand. My guess is that Burberry will be operating at normal levels within five years, and so I think it’s reasonable to assume that revenues, earnings, dividends and so on will be back to 2018/19 levels by 2025 or sooner. You can then make a judgement call based on today’s price and that assumption of an eventual return to normal.
Domino’s is very different in that the pandemic may not hurt its performance materially, although the dividend is suspended as a precautionary measure. I think Domino’s risks are more about getting (excessively) large franchisees back on good terms with management, and the risk of disruption from Deliveroo and Just Eat.
I guess my point is that you either go down the 100% mechanical route and invest purely based on the numbers, or you have to use judgement, and I prefer the latter. And in my case my judgements are based on where I think a company will be in five or ten years, not this year or next year.
More generally, I just try to invest in a diverse group of “special” businesses with good management, strong balance sheets, growing markets and so on, and I try to buy them at what appear to be attractive prices. The rest I leave up to the gods.
Having said that, I would try to avoid offline retail and travel at the moment, and I mentioned a few pandemic-specific considerations here:
https://www.ukvalueinvestor.com/2020/05/tips-for-investing-in-a-coronavirus-world.html/