Dividend sustainability: Meaning, Criticisms & Real-World Uses

What Is Dividend Sustainability?

Dividend sustainability, within the realm of investment analysis, refers to a company's ability to consistently generate sufficient earnings and cash flow to maintain or increase its dividend payments to shareholders over time. It is a critical consideration for income-focused investors who rely on regular dividend distributions. A sustainable dividend indicates financial health and a reliable stream of income, suggesting that the company's cash flow and profitability are robust enough to cover its payouts without jeopardizing future growth or financial stability.

History and Origin

The concept of dividend sustainability has evolved alongside the broader understanding of corporate finance and shareholder value. Historically, companies often viewed dividends as a signal of their financial strength and a means to distribute excess profits. However, the dot-com bubble and the 2008 financial crisis highlighted the precariousness of dividends when not underpinned by true financial durability. For instance, the COVID-19 pandemic saw a significant number of companies globally cut or omit dividend payments, with cuts totaling $220 billion between April and December 2020.⁷ This period underscored the importance of assessing a company's fundamental ability to sustain its payouts, moving beyond just historical dividend records.

Key Takeaways

Dividend sustainability assesses a company's capacity to maintain or grow its dividend payments.
It is crucial for investors seeking a consistent income stream from their portfolios.
Key factors include a company's earnings, free cash flow, and debt levels.
A high dividend yield alone does not guarantee sustainability; it can sometimes signal financial distress.
Analyzing financial statements is essential for evaluating dividend sustainability.

Formula and Calculation

While there isn't one single "dividend sustainability formula," analysts typically rely on a combination of financial ratios and metrics to gauge a company's ability to maintain its dividend. Two common ratios are the Dividend Payout Ratio and the Free Cash Flow Payout Ratio.

Dividend Payout Ratio

The dividend payout ratio indicates the proportion of earnings a company pays out as dividends.

\text{Dividend Payout Ratio} = \frac{\text{Total Dividends Paid}}{\text{Net Income}}

Free Cash Flow Payout Ratio

This ratio measures the percentage of free cash flow distributed as dividends, often considered a more accurate measure of sustainability than the dividend payout ratio because free cash flow is less susceptible to accounting manipulations than net income.

\text{Free Cash Flow Payout Ratio} = \frac{\text{Total Dividends Paid}}{\text{Free Cash Flow}}

For both ratios, a lower percentage generally suggests greater dividend sustainability, as the company retains more earnings or cash for reinvestment or to cushion against future downturns.

Interpreting the Dividend Sustainability

Interpreting dividend sustainability involves looking beyond just the current dividend yield. A high yield could be attractive, but it might also indicate that the stock price has fallen due to concerns about the company's future performance or its ability to continue dividend payments.⁶ Conversely, a low yield could be from a company that consistently increases its dividends over time, suggesting strong underlying business health.

Analysts often examine trends in a company's earnings per share (EPS) and free cash flow per share. Consistent growth in these metrics strengthens the case for dividend sustainability. Additionally, assessing a company's balance sheet for manageable debt levels and a strong cash position is vital. A company with excessive debt or declining cash reserves may struggle to maintain its dividends, even if current earnings appear sufficient.

Hypothetical Example

Consider two hypothetical companies, Company A and Company B, both paying a dividend of $1.00 per share.

Company A:

Net Income per share: $2.00
Free Cash Flow per share: $1.80

Dividend Payout Ratio: (\frac{$1.00}{$2.00} = 50%)
Free Cash Flow Payout Ratio: (\frac{$1.00}{$1.80} \approx 55.6%)

Company B:

Net Income per share: $1.20
Free Cash Flow per share: $0.90

Dividend Payout Ratio: (\frac{$1.00}{$1.20} \approx 83.3%)
Free Cash Flow Payout Ratio: (\frac{$1.00}{$0.90} \approx 111.1%)

In this example, Company A demonstrates stronger dividend sustainability. Its lower payout ratios indicate that it retains a significant portion of its earnings and cash flow, providing a buffer for future dividend payments and potentially allowing for future dividend growth. Company B, on the other hand, is paying out almost all its net income and more than its free cash flow as dividends, which could be an unsustainable practice over the long term. This scenario suggests a higher risk of a dividend cut for Company B.

Practical Applications

Dividend sustainability is a core consideration for investors building portfolios aimed at generating regular income, such as retirees or those seeking to supplement their current income. It informs decisions in:

Stock Selection: Investors often screen for companies with a history of consistent dividend payments and strong financial fundamentals to ensure future payouts. Firms with high economic moats and robust balance sheets are often favored.
Portfolio Construction: Understanding dividend sustainability helps in diversifying an income portfolio across sectors and companies, reducing the risk of a significant income drop if one company reduces its dividend.
Risk Management: Assessing dividend sustainability allows investors to identify companies at risk of cutting their dividends, thereby helping them manage portfolio risk. Companies in cyclical industries, like oil and gas, might see their ability to pay dividends fluctuate with commodity prices. For example, U.S. energy firms have recently cut oil and natural gas rigs due to lower prices, leading to a focus on shareholder returns rather than increasing output, which could impact future dividend sustainability.⁵
Financial Analysis: Professional analysts use dividend sustainability as part of their broader evaluation of a company's financial health and management effectiveness. Publicly available documents like the 10-K report contain financial statements crucial for this analysis.⁴

Limitations and Criticisms

While essential, relying solely on dividend sustainability analysis has its limitations. Some criticisms include:

Backward-Looking Nature: Many metrics used to assess dividend sustainability, such as payout ratios, are based on historical data. Past performance is not indicative of future results, and a company's circumstances can change rapidly.
Ignoring Growth Opportunities: Companies that retain a higher percentage of their earnings rather than paying them out as dividends might be doing so to reinvest in high-growth opportunities. A strict focus on high dividend sustainability could lead investors to overlook companies with significant growth potential that could lead to greater long-term total returns.
Industry Differences: What constitutes a sustainable dividend payout ratio can vary significantly across industries. A utility company, with stable cash flows, might have a higher sustainable payout ratio than a technology company in a rapidly evolving market.
Accounting Nuances: Financial statements, while providing valuable insights, can be subject to various accounting treatments and estimates. Understanding the footnotes to financial statements can provide deeper insights into a company's policies that impact reported figures.³ For instance, a private equity firm like Blackstone, which manages a vast portfolio of assets, may reinvest income back into properties and not pay dividends to shareholders during certain periods, even as its overall earnings are high.²

Dividend Sustainability vs. Dividend Yield

Dividend sustainability and dividend yield are two distinct but related concepts in dividend investing.

Dividend Yield is a financial ratio that indicates how much a company pays out in dividends each year relative to its stock price. It is calculated as the annual dividend per share divided by the current stock price. A high dividend yield might appear attractive, but it does not inherently guarantee that the payments will continue.

Dividend Sustainability, as discussed, assesses the likelihood of a company being able to continue paying its current dividend, or even increase it, in the future. This assessment involves a deeper dive into the company's financial health, including its earnings, cash flow generation, debt levels, and business outlook. A high dividend yield from a company with weak financials might signal an unsustainable payout, leading to a potential dividend cut. Conversely, a lower dividend yield from a financially sound company might be more sustainable and potentially grow over time. Investors focused on long-term income reliability prioritize sustainability over a fleeting high yield.

FAQs

What makes a dividend unsustainable?

A dividend becomes unsustainable when a company consistently pays out more in dividends than it earns in net income or generates in free cash flow. This often necessitates borrowing money or selling assets to fund dividend payments, which is not a long-term viable strategy. Signs of unsustainability can include a very high dividend payout ratio, declining earnings, increasing debt, or a negative free cash flow.

Can a company cut its dividend even if it has strong earnings?

Yes, a company can cut its dividend even with strong earnings. This might happen if management decides to retain more earnings for significant capital expenditures, debt reduction, strategic acquisitions, or to build a larger cash reserve during uncertain economic times. While less common when earnings are strong, it can be a prudent decision for the company's long-term health and future growth.

How do economic conditions affect dividend sustainability?

Economic conditions significantly impact dividend sustainability. During economic downturns or recessions, consumer spending may decrease, leading to lower revenues and profits for companies. This can strain a company's ability to maintain its dividend payments, as seen during the 2020 pandemic where many companies reduced or eliminated dividends.¹ Conversely, during periods of economic expansion, companies are generally more profitable and have greater capacity to sustain and even grow their dividends. Understanding the business cycle is therefore important for dividend investors.