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Two tools to understand dividends better
Dividend investing tool #1 – The dividend yield
The dividend yield, expressed as a percentage, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.
To calculate the figure, you take the dividend and divide it by the company’s share price times by 100. Always remember to use the same unit for the dividend and the share price (both should either be in rands or in cents).
So, for a 100c company paying a 5c dividend: 5 / 100 * 100 = 5% dividend yield
A R10 company with a 30c dividend would look like this: 30/1000*100 = 3% dividend yield
So, what you can gather from these two examples is that the 5c dividend translates to a 5% dividend yield for its company, whereas the 30c dividend translates to a 3% dividend yield.
The 5% dividend yield is the more attractive of the two.
You can also compare this with the interest you’d receive on a fixed deposit – which at the moment is around 4%. Investing in shares is risky so a higher return from dividends than the interest on a fixed deposit makes it more attractive to take that risk.
But a big dividend yield is worth nothing if a company cannot continue paying these dividends into the future.
Dividend investing tool #2 – The dividend cover ratio
The Dividend Coverage Ratio, also known as dividend cover, is a financial metric that measures the number of times that a company can pay dividends to its shareholders. The dividend coverage ratio is the ratio of the company’s net income divided by the dividend paid to shareholders.
The higher the ratio – the more cash the company will have in reserve to pay dividends in future, because it is keeping some of its profits.
The lower the ratio – the less cash the company keeps for itself, hence it might be limited in growth opportunities or could struggle to hold the dividend at high levels in the future.
The general formula for calculating DCR is as follows:
Dividend Coverage Ratio = Net income / Dividend declared
• Net income is the earnings after all expenses, including taxes, are paid
• Dividend declared is the amount of dividend entitled to shareholders
So, let’s take our company with the 5c dividend and R1 share price as an example.
Let’s say the company had 1 billion shares in issue, and made a net profit of R120 million for the year.
Its total dividend payout is then (1 billion x 0.05) R50 million.
So, to calculate the dividend cover ratio:
Net income / total dividend declared: 120 million / 50 million = 2.4
This means the company can pay its dividend 2.4 times with the profit it made in that year.
So, it can most likely even continue to pay that dividend in a tough year.
Let’s use the same example, but say the company made only R60 million net profit. Then its dividend cover would be 1.2. In this case there’s very little profits being retained, and the company would struggle to keep up this dividend if there was a tough year ahead of it…
So, when we look at dividend cover, we want a company that shares profit with us, but it has to be balanced in order to keep some cash on hand for growth and tough times as well. So, I like a dividend cover above 2 and below 4.
Using these two ratios you can start ranking companies on their dividend yield, and the sustainability of their dividends before investing in them. That way you’re more likely to pick the good ones from the bad.
Here’s to unleashing real value,
Editor, Red Hot Penny Shares