Dividend Payout Ratio and Distribution Coverage

Yesterday, I received another “support” case of a Facebook user. She asked about why some companies paid more than 100% dividend payout. Here, I am not going to explain the reason, but I will discuss a bit usage of dividend payout ratio and how to assess capability of a company in paying dividend.

First of all, you don’t have to calculate dividend payout ratio by yourself. You can get the value from Bursa Market Place, financial services, etc… And here is the definition: http://www.dividend.com/dividend-education/the-truth-about-dividend-payout-ratio/

Dividend payout ratio basically uses earnings as a measurement to assess whether a company is generous or not. By definition of this ratio, high dividend payout is probably not sustainable. Nevertheless, this doesn’t explain why some companies can consistently pay out high dividend, i.e. >90% payout every year. As a layman, there is no logic where a company keep distributing out almost all or more than its earnings. How can the company survive?

In my opinion, the key thing is CASH FLOWS. Earnings is not equivalent to cash flows. Also, when a company distributes dividend, they don’t distribute “earnings”, but CASH.

So, to assess the capability of a company to pay handsome dividends in long term, we can consider to use another ratio: Distribution Coverage.

Formula of Distribution Coverage: (Funds Flow from Operations – Capex) / Distributions.

Funds Flow from Operations: Cash flow from operations before changes in working capital and changes in other short-term and long-term operating assets and liabilities

Capex: Gross expenditures for plant and equipment and intangible assets, per the Investing activities section of the Consolidated Statement of Cash Flow

Distributions: Dividend paid, per the Financing activities section of the Consolidated Statement of Cash Flow.

The distribution coverage ratio is a measure of cash flow coverage distributions, as a reflection of a company’s financial policy. The ratio is defined as Funds Flow from Operations (FFO) less maintenance capital expenditures divided by distributions. Maintenance capital expenditures are generally based on public disclosures of maintenance capital spending or, if not disclosed, 100% of a company’s annual depreciation and amortization expense, and forward view of maintenance spending requirements. Companies with lower payouts and which apply free cash flow towards debt reduction and reinvestment map to higher ratings. High distribution coverage provides companies with cushion during periods of weaker earnings, particularly those companies with higher levels of cash flow volatility, and provides a higher level of financial flexibility.

By Moody’s guidance,

= 10x – Aaa
>= 5x and < 10x – Aa
>= 2x and < 5x – A
>= 1.4x and < 2.0x – Baa
>= 1.2x and < 1.4x – Ba
>= 1x and < 1.2x – B
< 1x – Caa

In a simple terms, if the coverage is high, it means the company actually has no problem to payout high dividend.

Nevertheless, generosity of a company is completely at the management’s discretion.

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