Generating consistent income is a wonderful way to grow your wealth. And one of the best ways to make consistent income is with dividends.
However, finding the right companies that can consistently pay you dividends every year isn't all that easy.
Unfortunately, you'll get companies that pay-out most of their profits in dividends. Eventually, they won't be able to sustain this. This happened to blue-chip company Famous Brands over two years ago. The company was forced to scrap its dividend after 13 years of consistent pay-outs and its shares consequently crashed over 20%.
So how can you check if your investments can sustain their dividend pay-outs?
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Always check this “pay-out” ratio
It's called the "dividend-pay-out ratio."
By definition, it’s the percentage of earnings the company pays out as dividends, usually on an annual basis.
But as an investor, what you’re looking for in a dividend-pay-out ratio is sustainability.
For example, a dividend-pay-out ratio of more than 100% is usually not sustainable.
At that pace, the company will eventually run out of money.
Likewise, a low dividend-pay-out ratio suggests the company isn't returning much money to shareholders.
A sustainable pay-out ratio should be higher than 30% but no more than 60%. This suggests the company pays a generous dividend and still has breathing room in the case of short-term market fluctuations.
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Where you can you find the dividend pay-out ratio
You can find this number when a company releases its financial statements.
Or to work it out is very simple: If a company reports earnings of 50c and dividends of 25c, its dividend pay-out ratio is 50% ((25c/50c)*100).
The bigger the gap between a company’s dividend and its earnings, the better the chance the company has of maintaining it if earnings come under pressure.
As earnings can sometimes be manipulated through the issuing of new shares, another way to work out dividend pay-out ratio is to use free cash flow per share. The more cash a company generates, the more likely it is to pay out dividends.
You’ll also find this in a company’s financial statements.
So next time, when you’re looking for consistent dividend-payers to invest in, make sure you check the dividend-payout ratio.
See you next week,
Managing Editor, Real Wealth