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Warning Sign #1: When a company cash flow deteriorates
The main reason you buy a dividend stock is because it actually PAYS a dividend right?
So, to identify if a company's dividend is sustainable, the first place you should look is the company's cash position.
Consider both the cash in the company's balance sheet and its ability to generate cash flow. If a company's cash flow is declining or it's taking enormous amounts of debt, its ability to pay a dividend will also diminish.
A good example of this would be property company Rebosis – Last year its share crashed +80% because the company accumulated too much debt, while its properties weren’t generating sufficient income.
However, a company that is consistently generating cash won’t only pay you dividends, but grow them too!
Just consider from 2018 to 2019, JSE-listed Afrimat’s iron ore investment grew revenue and operating profit by a whopping 287% and 702%, respectively. It also boosted the company’s cash pile by 100% year-on-year!
And, the more cash a company generates, the higher chance it will grow its dividend. And Afrimat did exactly that in 2019 - boasting an almost 61% dividend growth!
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Warning Sign #2: When a company’s profit or sales growth declines
Earnings season also reveals which companies can sustain their dividend payments. You see, when a company has weak fundamentals, it can't rely on sales growth or earnings growth to improve its cash flow.
Instead, it must look at what it can cut to make up the difference and free up cash. And to do this, a company will usually cut dividends or suspend share buyback programs.
In most cases, it doesn't matter how many consecutive years a company has paid a dividend or how consistently it's increased the payment over time. Many companies will prioritise cash flow first because that's the way they keep their businesses running.
A number of companies are releasing their results right now, simply go to SENS when you want to find out about your stocks earnings.
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Warning Sign #3: When a company’s share price falls, while its dividend yield rises
When a business runs into money problems, it will look for less sustainable ways to support their dividends. For example, a company may cut costs, using cash originally allocated for basic operations or capital investment to fund dividend payments.
In other instances, a company may take on more debt or sell shares to raise more funds to support dividend payments.
What's interesting is when this happens behind the scenes, the company's dividend yield grows more attractive to yield hungry investors.
That's because the dividend yield is rising, as the company's stock price is falling.
But if these investors don't look under the hood to uncover the real reason for rising dividends, they could be in a heap of trouble when the company ultimately can't maintain its pay-outs and cuts the dividend.
So, in short, you must keep in mind the warnings signs I mentioned above when analysing dividend stocks.
Regular income from a dividend stock can be a great benefit, but that doesn't mean the stock will be the best pick for you forever.
See you next week.
Managing Editor, Real Wealth