It might shock you to know, but:
Dividends are NOT guaranteed.
It's tough, I know, but there is nothing to stop a company's board from refusing to pay you a dividend. They are after all discretionary.
Indeed, a dividend can only be paid once the following three rules are met:
- Net assets (assets less liabilities) can cover the dividend
- The dividend is fair and reasonable to all shareholders; and
- Paying the dividend won't jeopardise a company's ability to pay creditors
That means it's up to the board of directors to prove a dividend is in the best interests of all stakeholders. However, even if they can prove it's a good idea, it doesn't mean they will – or should – pay a dividend. Should and will are two completely different questions.
Will my company pay a dividend?
If you're wondering whether your company has the propensity to pay dividends, read through its annual report and find its dividend guidance or dividend policy. Most reputable company websites contain a 'dividend' section within its shareholder or investor services portal.
Should my company pay a dividend?
Knowing whether a company should pay a dividend is a different question entirely.
As Investopedia says:
Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price.
In Australia, dividends with franking credits are extremely tax-effective. Therefore, anecdotal evidence suggests dividends indeed have a meaningful effect on share prices.
Nonetheless, determining whether a company should pay a dividend usually revolves around its sustainability because legislation only goes so far.
Some analysts suggest profit is an adequate measure for determining a dividend's sustainability. However, I think free cash flow is probably the best proxy for the assessing the viability of a dividend – not profit – because it takes into consideration the capital required to be reinvested in the business.
Two companies that I believe may cut their dividends because they will require heavy amounts of reinvestment in coming years are Woolworths Limited (ASX: WOW) and Woodside Petroleum Limited (ASX: WPL).
Another two resources companies that I believe have unsustainable dividends are BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). Their revenues will slump in coming years, taking profit and cash flow along with it, as a result of plunging commodity prices.
The banks
Free cash flow cannot be used to determine the sustainability of the dividends of Australia's (very) heavily leveraged major banks. Therefore, forecasting their profits and payout ratios over time, combined with a significant qualitative overlay, is a useful barometer for assessing their dividends.
Anyone who's done a fair share of research into the state of the Australian economy (property markets, credit growth, bad debt cycles, China, etc.) will know the outlook is anything but rosy. Combined with very high forecast payout ratios, I wouldn't buy Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd. (ASX: NAB), Westpac Banking Corp (ASX: WBC) or even Australia and New Zealand Banking Group (ASX: ANZ) shares for their dividends at today's seemingly discounted prices.
Bank dividends are hard to forecast at the best of times, let alone when the economic outlook is mixed, and confidence is choppy – and particularly after 24 years without a recession. A recent uptick in bad debts presents downside risk in my opinion.
Foolish Takeaway
Dividends are great when they're paid out of recurring cash flows and the business has an excellent balance sheet. However, if they're unsustainable they can be a very poor use of shareholder capital – and shareholders will likely see the dividends cut eventually anyway.
