Show me the money! That’s exactly the message when you receive the dividend payment from your equity investments.
The money is real, and a company cannot just pay out dividend based on profit as profit is an opinion, but cash flow is a fact. A company could borrow money to pay the dividends or dip into its existing cash balance to pay the dividends or sell assets to pay dividends, these methods do not appear sustainable to me in the long run.
Usually dividend investors would like to know how safe is the dividend payment received, you would not want to pin hope on dividends stream which are not sustainable in your quest towards financial independence.
The magic formula that comes in handy will be the free cash flow to dividend cover ratio.
Dividend coverage = free cash flow over dividend payout
Assuming a company generates net operating cash flow of RM100 mil and after taken care of investing outflows i.e. capital expenditure of RM30 mil, there is free cash flow (FCF) of RM70 mil which the company could use to pay off debts, or build up its cash reserves or to fund the dividend payment.
Assuming dividend payout is RM50 mil, the company could easily fund this dividend payment via its RM70 mil FCF without the need to sell assets, or raise debts or tap into existing cash reserves.
The dividend cover translates into a comfortable ratio of 1.4x (RM70 mil FCF / RM50 mil dividend payout), I would be glad if my invested company has a dividend cover of at least 1x.
Failing which, there could be a risk of dividend cut if FCF is less than dividend payout on a prolonged basis as a company could not keep borrowing indefinitely to pay dividend amidst finite cash reserves. Moreover, if the company has high dividend payout ratio, insufficient FCF to cover dividend payout might signal potential future dividend cut.
So, make FCF to dividend cover ratio your good friend when you hunt for your income stock! Remember to check the ratio to gauge if the dividend payment is safe!