For an investor, dividend sustainability more important than mere high dividends given the long-term interests and benefits. This can be better understood from the following:

Understanding the dividend payout ratio: Dividend payout ratio is a key metric for investors as it represents a ratio of profit shared with shareholders. The balance of profit is kept in business to invest for future. The dividend payout ratio is one of the tools to anticipate or assess the dividend sustainability. In case of growing company, the ratio is very low or may be zero as company wants to invest more in business to grow but in the case of mature businesses the dividend payout ratio is generally high. Thus, the trend in payout ratio indicates the future dividend payout for the company. A steadily rising ratio could indicate a healthy business state or maturing business while a spiking dividend payout ratio sometimes may indicate that the dividend is heading into unsustainable territory. Many companies set a target for their payout ratios. They define it as a percentage of sustainable earnings or cash flow. Typically, companies with best long-term record of dividend payments have stable payout ratios over many years.

Consistency in dividend payment: Consistency in dividend payout is important as the same is indicative of company’s willingness to distribute profit to the shareholders. Sometimes the company pays more than 100% of their profits to reward their shareholders, which gradually might result into lower payout in coming years.

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Trend for Dividends and Profits (Source: Reserve Bank of Australia)

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Strong cash flows generally enable firms to give more dividends: Some companies generate good amount of cash flows over and above the need for reinvestments. Such companies pay dividend at a comparatively good rate. This may not be the case always. Healthy businesses are known to be associated with large amount of cash flows and earnings. The dividend amount should be covered by the amount of cash coming into business for looking at sustainability. As experts have analyzed, the dividend sustainability sits on the cash in hand instead of subjective earnings accrual number. Companies with high earnings but with low cash flow thus fail easily in terms of paying dividends while company with comparatively low earning but good cash flow will be able to pay high dividend. Cash flow may also be impacted by depreciation and non-cash charge against earnings. It has been seen that many capital-intensive companies like telecommunication companies, real estate investment trusts have low earnings but high cash flows.

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Sources and Uses of Cash Flows (Source: Reserve Bank of Australia)

Free cash flow is a better indicator: Considering the flaws of cash flow, the better indicator is free cash flow which indicates for the cash flow available to pay out in dividends post the settlement of all other claims on the company’s cash flow. Good free cash flow generating companies would determine dividend sustainability. However, dividend sustainability on free cash flow doesn’t work for REIT and Master Limited Partnerships (MLPs). This is because their business models are based on constant and massive capital expenditure. The massive capex is funded by equity and debt issuance, which allows the business model to maintain the necessary cash inflows.

Cyclicality of business: Companies in cyclical sectors like resources and energy typically have lower payout since the earnings fluctuate considerably as per the economic cycles. In high price environment for commodities, the cash flow and earnings are high while with fall in commodity prices the profits as well as cash flow are poor, which is likely to take a dent on dividend. Best example is oil – oil companies are now suffering due to fall in prices, which also have pressurized their dividend payments.

Blue chip companies generally deliver better dividends: Blue chip companies often increase their dividends year after year with their steady earnings growth. Their payout ratio remains stable over extendable periods.  The healthy business growth year on year is a good indicator of rising profits and earning healthy cash flows. This is also an indicator of sustainable dividend payout.

Dividend payout from reserves: Dividend payout from reserves to inflate stock price is another strategy that has come into light. Sometimes, a company pays dividend out of their reserves and not from their earnings or healthy cash flows. However, this may be a dangerous sign and indicates that the dividends are unsustainable.

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Disclaimer

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