Dividends are one of the best reasons to hold shares in Australian companies.
But dividends are not created equal. And they're certainly not guaranteed.
In fact, under law, a director must prove that the dividends his or her company wishes to pay will not jeopardise the company's financial position.
However, generally, there are two things that make up a good dividend stock:
- Reliability of dividend payments; and
- Capital appreciation.
Assessing the reliability of a dividend isn't always easy. Indeed, there's no set formula. However, there are few things we should look for, including:
- Profitability – Does the business generate good or great returns for every dollar that walks in the door?
- Recurring revenue – Will the business continue to grow sales in one, two, or ten years from now?
- Track record – Does the business provide a service that people know, trust and need?
- Balance sheet strength – Is heavy, stinky, costly debt eating away at the business from the inside? How does free cash flow compare to dividends?
- Risks – What are the major risks? Think competition, regulatory risk, people risk, etc.
The capital appreciation component is also vital. For example, if you bought BHP Billiton Limited (ASX: BHP) shares a year ago, when they were trading around $30 and yielding a fully franked dividend of 5.3%, you would've received the expected dividend, sure. However, today you would be sitting on a net loss of 46% on your total investment since its share price now trades at just $17.32.
The takeaway here is to get a reliable dividend and share price growth.
After all, if we wanted zero capital growth, we could just buy a term deposit.
So, now, let's take a look at two dividend heavyweights to see how they stack up: National Australia Bank Ltd. (ASX: NAB) and Telstra Corporation Ltd (ASX: TLS), two of Australia's favourite income stocks.
Dividend Reliability
Profitability
Although it should never be used in isolation, the return on equity (ROE) tells us how much money a company makes for every dollar of shareholder ownership. As can be seen, Telstra consistently generates more profit for every dollar of shareholder funds, than NAB.
Recurring Revenue
There's no single line item that tells us specifically how much revenue is recurring. Indeed, there is no substitute for rigorous qualitative analysis. However, anyone who has a mortgage or mobile phone contract will know both these companies offer products which by their nature produce long-term recurring revenue for the company. As can be seen above, in recent years, NAB's relative revenue growth has outpaced that of Telstra.
Track Record
Over the past 10 years, Telstra has achieved a total shareholder return (dividends plus capital gains) of 11.1% per year, compound. NAB's figure stands at 5.2% per year.
Balance Sheet Strength
NAB is a bank and Telstra is an industrial business, so their balance sheets differ in many ways. Indeed, NAB recognises deposits as debt and debt as assets.
However, NAB's use of debt, together with the cyclical nature of the banking industry, mean it's imperative for the bank to monitor its deposit and wholesale funding mix, price loans accordingly, and have a very robust risk-management mandate.
If I was to compare the companies off hand, I'd say Telstra has a more resilient balance sheet because of its wide profit margins and leading position in key markets. Indeed, NAB's balance sheet will be more sensitive to interest rate movements and the economic environment because its profit margins are much smaller than Telstra's.
Risks
The major risk to NAB is a deep recession. Unprecedented growth in household debt levels and soaring house prices doesn't end well for any bank. Fortunately, that appears a low probability at this time.
For Telstra, the key risks (as I see them) are competition and technological. Its overseas expansion into Asia could also prove costly.
Capital Appreciation
Every investor would love to know where a company's share price will go – if you have a crystal ball or a time machine, be sure to let me know!
The best way for a dividend or value investor to assess the downside risk of a share is by making models that incorporate both the probability and consequence of risk. Only then, can we determine a fair price to pay for shares.
Frankly, I find NAB difficult to value in absolute terms (I think any human would) given the complexity of its balance sheet and the nature of its business. However, previously, I said $20 would be a good price to pay for its shares.
Conversely, I think Telstra would be a good buy around $5. However, I'd never be prepared to guarantee a return.
And the best dividend stock is?
In my opinion, Telstra appears the winner of the dividend duel. It's a market leader across many defensive product lines and doesn't carry the cyclical macroeconomic risks associated with NAB. Furthermore, it's easier for me to get my head around.
Indeed, although I know a lot about the banking sector, the further an investment proposition moves from the centre of my circle of competence, the bigger margin of safety I demand. Accordingly, NAB appears further away from my ideal buying price than Telstra.
