Calculate a payout ratio and decide whether a dividend is covered.
Two colleagues each give their parents S$500 a month. One earns S$4,000 a month, and the other earns S$1,200 and makes up the rest with a credit line (both are example figures). The gift is the same, but only the first colleague can keep giving it next year.
Dividends work the same way. The size of a company's payout tells you very little until you compare it with what the company earns.
The payout ratio is dividends divided by earnings. You can work it out per share, by dividing dividends per share by earnings per share, or in totals, by dividing total dividends by net profit. Both give the same answer.
Say a company made a net profit of S$200 million last year and paid S$130 million in dividends, an invented example. S$130 million / S$200 million = 65%. The company paid out about two thirds of what it earned and kept a third. Earnings that are not paid out can be reinvested, used to repay debt or held as a buffer.
A payout ratio above 100% means the company pays out more than it earns. The excess has to come from cash saved in earlier years, from borrowing, or from selling something. As Lesson 1.2, "Where dividends come from and how often they are paid", explained, this can go on for a while but not indefinitely.
Earnings are produced by accounting rules, and those rules involve judgement: when revenue counts, how fast equipment is depreciated, what an asset is worth. A company can report steady earnings while very little cash actually comes in, so you should run the same payout test against cash as well.
Free cash flow is the cash generated from operations minus spending on capital items such as equipment, buildings and systems. It is the money left over that could pay a dividend without borrowing. You'll find both operating cash flow and capital spending in the cash flow statement in the annual report.
Go back to the same company. Its operating cash flow was S$260 million and it spent S$150 million on capital items. S$260 million - S$150 million = S$110 million of free cash flow. Set the S$130 million dividend against that, and S$130 million / S$110 million = about 118%.
So the company pays out 65% on earnings and about 118% on free cash flow. A free cash flow payout above 100% in a single year can have an innocent cause, such as a big one-off investment. Several years in a row above 100% is a warning sign, and it is one of those listed in Lesson 3.2, "Warning signs that a dividend is about to be cut". When you see a gap like this, look at earlier years before you draw a conclusion.
The purpose of the ratio is to measure how much room is left before the dividend is threatened. At a 50% payout, profits could halve and the company could still pay the dividend without dipping into savings. At a 95% payout there is almost no room, and a small fall in profits forces a choice between cutting the dividend and funding it from somewhere else.
No single payout ratio is right for every business. A mature company with steady sales and little need to reinvest can safely carry a higher ratio. A company whose profits swing with the economy or with commodity prices needs more room. Read the ratio alongside the business: a high ratio in a steady business is a smaller concern than the same ratio in a cyclical one.
Banks and REITs are both large dividend payers on SGX, and neither fits the usual test.
A bank holds capital to absorb losses, and MAS sets the capital rules banks must meet. A bank's dividend depends on its earnings and on how much capital it holds above what the rules require. Free cash flow means little for a bank, because lending and taking deposits is its business. For a bank, read the payout ratio on earnings together with the capital ratios reported in its results, then check the current requirements on the MAS website to see how much margin it has.
REITs pay out most of their income by design, for reasons explained in Lesson 4.2, "The payout rule and tax transparency". A REIT payout ratio of 90% or more is normal and means the REIT is doing what it is built to do. A ratio that would alarm you in a manufacturer tells you nothing about a REIT. The tests that apply to REITs are covered in Module 5.
First confirm the company is not a bank or a REIT. Then take four numbers from its latest annual report:
Net profit attributable to shareholders, from the income statement Total dividends declared for the financial year, from the dividend note, adding the interim and final dividends and leaving out any special dividend Operating cash flow, from the cash flow statement Capital expenditure, from the cash flow statement
Divide dividends by net profit to get the payout ratio on earnings. Subtract capital expenditure from operating cash flow to get free cash flow, then divide dividends by free cash flow to get the free cash flow payout. Compare the two ratios and work out what explains any gap between them. If the free cash flow payout is above 100%, check whether it is a one-off or has repeated over several years. Then judge how much room is left against the type of business, steady or cyclical.
In the activity you will pull those four numbers for one SGX company and calculate both ratios. The gap between them, if there is one, is what you will want to explain.
Take the latest annual report of one SGX company that is not a REIT and work out its payout ratio on earnings and on free cash flow.
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