Dividends are one of the easiest ways to get cash flow or passive income from your investments.
If you are investing in dividends, this article presents information on how to know if your dividends are going to be sustainable.
One of the biggest mistake dividends investor make is to chase for high dividend yield companies.
What Is Dividend Yield?
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For example, Coca Cola (KO) currently pays an annual dividend of $1.60. If the current share price is at $53.74 then the dividend yield would be $1.60/$53.74 = 2.98%
Many investors make the mistake of chasing companies which are paying 10% or even 15% dividend yield, not realizing whether the dividends are sustainable or not.
How To Determine Sustainability?
If you are investing for financial freedom, you will definitely want to know if your dividend-paying company is going to keep paying you dividends year after year. So how do we know whether the dividends are sustainable?
To determine the sustainability of dividends, I personally check for these two criteria:
- Dividend Payout Ratio
- Free Cash Flow Per Share
What Is Dividend Payout Ratio?
The dividend payout ratio refers to the percentage of earnings being distributed as dividends.
For example, let's look at 3M and its dividend payout ratio.
Image Taken From Morningstar.com
From Morningstar, we can see the 3M payout ratio has been paying out around 50% - 70% of their earning as dividends in recent years.
Personally, as long as the dividend payout ratio is below 70%, I will think it is considered sustainable.
There are companies out there which are paying more than 100% of their earnings as dividends - and this is clearly unsustainable, and you should avoid investing in them.
What Is Free Cash Flow?
Free Cash Flow refers to the cash that is left over after a company's capital expenditures. This means this cash flow can be used to distribute dividends, reducing debt or even share buybacks.
To know if a company's dividend is sustainable, we can look at the cash flow per share on its financials.
Let's look at 3M again.
We can see in 2018-12, the free cash flow per share of 3M is 7.47 while the dividend per share is 5.44. This means that 3M has no problems paying out dividends from its free cash flow.
As a general guide, if the free cash flow is more than the dividend per share, the dividends tend to be more sustainable.
Only Invest In Sustainable Companies
Many beginner investors are chasing high dividend yield companies without evaluating the sustainability of these dividends.
As a result, while they are receiving these 10% to 15% dividends and often these companies are paying out more dividends than they are earning. Eventually, these companies will have to cut their dividends payment, resulting in a plunge a share price - offsetting all the dividends received over the years.
My Personal Thoughts
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The reason why I wrote this post was because most people invest in the stock market for dividends as a means of getting passive income.
While I personally don't invest in dividend stocks now, I wanted to give some guidance on those who have just started their investment journey so that they do not fall into the trap of investing only for the sake of high dividend yield, without assessing its sustainability.