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!