Before buying a company, many investors ask "what's the dividend like?" People naturally want a better return than a term deposit. But relatively few investors ask "Why is this company paying me a dividend?" or "Where does the dividend come from?" and I believe that the latter two questions are far more important.
- Why is this company paying me a dividend?
To share the profits with shareholders, obviously. Or it can be because the company can't reinvest the money effectively back into its business. One unintended side effect of a dividend policy is that it can also help restrain empire-building or 'diworseification'.
However, it's always important to ask why a company is paying a dividend instead of using the money for another purpose.
For example, Baby Bunting Group Ltd (ASX: BBN) paid out 87% of its cash flow from operations as dividends in the past year. Yet at the same time, the company announced it would have capital expenditure of $7.4 million (56% of cash flows) in 2018. Board policy is to pay out 70%-100% of profit after tax, at the same time as trying to grow the store network from 43 to ~100 stores, which suggests frequent use of debt.
Would the company be better off with a lower dividend and reinvesting the money? That's something for shareholders to consider. Some businesses like Dicker Data Ltd (ASX: DDR) have done very well despite paying out most of their earnings.
- Where does the dividend come from?
Some large companies like Telstra Corporation Ltd (ASX: TLS) 'smooth' their dividends by paying with debt. This can happen when a company wants to pay a dividend but won't receive the cash for the dividend in time to pay it – e.g. due to the timing of a large project payment.
Some smaller companies like Lifehealthcare Group Ltd (ASX: LHC) use a similar practice. Lifehealthcare paid its first-half dividend from debt, which was in my opinion an unsafe decision given the company's limited cash balance and working capital requirements. Lifehealthcare is much smaller and its sales are more tenuous than Telstra.
The best dividend policy
In my opinion, the best dividend policy is 'business first, shareholders second'. If a dividend must be paid with debt, or if paying a high dividend results in a company requiring more debt to fund its expansion, my view is that the dividend should be trimmed. Doing otherwise is like trimming a tree's roots instead of its leaves.
With today's low-yield and low cost of debt environment, I think it's become a little too easy for companies to maintain their dividends to shareholders, which is ultimately to the shareholders' detriment.
