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Why you should always question these high dividend shares
You need to always remember – dividend yield is a backward-looking ratio.
That means it tells you the income you ‘WOULD HAVE’ gotten from a share based on its last dividend and its current share price.
This doesn’t in any way imply that the dividend yield can be maintained going forward.
Take Steinhoff for example…
Following its 2017 crash, the share traded on a dividend yield of around 20% in early 2018.
But that was based on a dividend it paid in March 2017.
Following its crash, it became clear that Steinhoff wouldn’t be able to pay dividends again any time soon. The company was basically bust because of fraud.
Had you however only looked at what was in front of you on paper – the company would’ve looked incredibly attractively priced…
When a dividend yield is high you need to question its sustainability
The market does make ‘mistakes’ when pricing shares… Sometimes a share is on a high dividend yield because it is little known and the market doesn’t recognise it.
But sometimes a share tanks in price because of trouble brewing – and its historical dividend yield looks attractive even though the future dividends will also crash.
That’s why you also need to investigate whether a company can sustainably continue paying the dividend.
There are a couple of things you can do to investigate this. Some are also simple share ratios. Others need you to investigate much deeper.
How to spot if a dividend can be sustained or not?
Unsustainable dividend sign #1 – Check the dividend cover
Dividend cover is a ratio that tells you how much of profits are paid out as dividends. When a company pays out all of its profits, or in some cases they even pay out more dividends than they made profit, you should see warning lights.
A dividend cover of less than 1 means a company pays more dividends than it makes profit.
Unsustainable dividend sign #2 – Weak cash flows
You want to check if a company gets cash flows equal to (or at least close to) its profits. If a company makes lots of credit sales (which will show high profit) but little of the credit is turned into cash flow, watch out…
Many companies inflate profits with credit sales. Only to show large bad debts later.
Only trust dividends when the companies paying them are cash flush.
Unsustainable dividend sign #3- Try looking into the future a bit
None of us have crystal balls. But we can forecast what will happen in the near future to some degree…
Take Steinhoff for instance. In December 2017 it crashed. News about fraud and accounting irregularities came out. Shareholders spoke about lawsuits against the company. Creditors spoke about closing lines of credit to the company.
All of this are warning signs that show the future is not going to be favourable for the company’s ability to pay dividends going forward…
So, with this in mind, why did I say I don’t trust Quantum Food’s 16% dividend?
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Why Quantum’s 16% dividend won’t be sustained
Simply looking at the financial ratios in Quantum’s case doesn’t raise warning signs.
The company maintains a dividend cover ratio of more than 1. And it’s cashflows were pretty strong in the past two accounting periods.
But there’s a massive warning sign if you look a slight bit into the future of the company…
You see, Quantum sells chickens and eggs.
Chickens eat a lot of maize.
And the maize price has been very volatile lately.
Two years ago, we had a drought. That sent the maize price up and Quantum’s profits down. The drought broke and the maize price hit lows in 2018 – sending Quantum’s profits soaring. Its dividend followed.
But 2019 has seen drought conditions in the Free State, meaning much lower maize yields are expected, after lower planting figures as well.
In May 2018 the yellow maize price was around R2,200. Today it is closer to R2,900. That means an increase in costs of more than 31% to feed producers.
This already affected Quantum in its interim results, with profits at 45.4cps compared to 82.5cps. For the full year I’d be surprised if Quantum manages more than 65cps in earnings. And that’ll see its dividend drop from a 16% dividend to a 4% dividend.
In short – watch out for overly exciting dividend yields… They tend not to last.
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