High Dividend Paying Companies – The Two Sides of a Coin
I was reading a book called “Investment Fables” written by Aswath Damodaran and came across a very insightful chapter on High Dividend Stocks. I realized that most of us know the good side of such companies. So let me highlight some of the interesting facts which constitute the other side of such companies.
High dividend paying companies are considered a superior investment option by its proponents. A comparison is made between such companies and government bonds. They argue that you get the “best of both the worlds”, i.e. companies which give high dividend are like bonds with price appreciation, thus making them appear as less risky and high return investment avenues.
While this is true to some extent, it has its limitations too. Mostly we tend to ignore the downside risks associated with such companies and fall prey to the believers of high dividend paying companies. We should be thorough with our research before we invest in such companies. Let’s see what all do we need to do.
There are two sources of return from a dividend paying company. First is the dividend which can be compared with the coupon income which we receive from investing in bonds. Second is the return we get due to price appreciation where bonds have a limited potential.
Giving out high dividend indicates that the company is reinvesting less amount of money in the business. This could be because due to several reasons. It can either be that the company currently does not require much money to sustain or grow the business or it has reached a level where it cannot utilize the shareholder’s funds in a better way than they have been doing till now. It could also be because it belongs to an industry/sector with more stable income and has less growth potential.
So what does it mean? It implies that since the company is not reinvesting much money into the business the potential for it to grow its earnings at a high rate also gets restricted. Thus on one side we are receiving high dividends and on the other side it translates into low expected growth rates in earnings. It’s a tradeoff that we need to take a call on.
There is more to high dividend companies. Such companies are not obliged to continue to pay dividends unlike bonds thus increasing the risk. Moreover, an investor has to pay a tax of 15% on his dividend income apart from capital gains tax.
So if you decide to invest in high dividend paying companies, then it is also very important for you to know if the dividend payouts are sustainable or not?
How do we know if a company is giving sustainable dividends?
There are three approaches to check if a company is paying sustainable dividends:
1. Payout Ratio: Compare the dividend to earnings in the most recent period to see if too much is being paid out. A 67% (two-thirds of earnings – the upper limit) payout ratio can be used as a Rule of Thumb. This is to say that that one should avoid companies that pay out more than two thirds of their earnings. Treat 67% as the upper limit.
Payout Ratio = Dividend/Earnings in the recent period
2. Average Payout Ratio: Compare dividends to normalized or average earnings over time.
Payout Ratio = Average Dividend / Average Earnings
3. Long Term Expected EPS Growth Rate: Check how much the company could have paid in dividends, allowing for the reality that firms have to reinvest money to grow their earnings.
LT Expected EPS growth rate = (1 – Payout Ratio) / Return on Equity
Here, Return on Equity = Net Profit / Total Shareholders’ Funds
Rather than looking only for high dividend paying companies, an investor should screen based on multiple criteria. These could include sustainable earnings and reasonable growth rates along with high dividend.
Thus by looking at high dividend paying companies in a broader perspective, I hope that you will be able to take a more informed decision.