# Dividends greater than Earnings??



## Warren Greenspan (17 June 2009)

My brother has just asked me to explain to him how some companies can consistently pay dividends per share that are higher than earnings per share.

APA is a good case in point. WDC another.

I'm sure the explanation is obvious but it escapes me.

Can someone help? (In simple terms please)

Warren


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## ROE (17 June 2009)

Warren Greenspan said:


> My brother has just asked me to explain to him how some companies can consistently pay dividends per share that are higher than earnings per share.
> 
> APA is a good case in point. WDC another.
> 
> ...




By revalue their asset and count that as profit and dip into capital and debt to pay out..

Not a good practice ..I be careful with these companies...

You see exceptional company payout ratio is 60-80 of their earnings...and keep the rest for growing the business without resort to debt...
these companies are far and few but they do exist ..your job is to snap them up when mr Market treat them the same way as bad companies


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## Warren Greenspan (17 June 2009)

Thanks ROE...makes sense, however I'd always thought that APA and WDC had fairly astute/conservative/reputable managements.

Could there be any other less sinister explanations?


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## stoxclimber (18 June 2009)

ROE said:


> By revalue their asset and count that as profit and dip into capital and debt to pay out..




If they're revaluing their assets and realising profit from that, then that would increase their profit - not what the OP was asking which is companies with low earnings but high dividends.

What's happening is that the company is paying down debt by using the asset cash flow, and then borrowing to fund the distribution. E.g. Say WDC owns shopping centres worth $10bn, funded by $5bn debt $5bn equity. The centres generate $500m in a year, and that money will go to making interest payments on debt, with whatever's left over going to NPAT. What they can do is either direct all spare cash to debt paydown (which essentially delivers returns to equity holders via capital gains) or also provide some steady returns to equity holders via dividends (i.e. returns as income). If they choose the latter, they'll borrow to help fund that distribution. There's nothing inherantly shady about that, although its not sustainable to continuously increases the D/EV ratio to fund dividends. However, its possible to pay dividends while maintaining a constant D/EV or reducing D/EV over time.


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## skyQuake (18 June 2009)

stoxclimber said:


> If they're revaluing their assets and realising profit from that, then that would increase their profit - not what the OP was asking which is companies with low earnings but high dividends.
> 
> What's happening is that the company is paying down debt by using the asset cash flow, and then borrowing to fund the distribution. E.g. Say WDC owns shopping centres worth $10bn, funded by $5bn debt $5bn equity. The centres generate $500m in a year, and that money will go to making interest payments on debt, with whatever's left over going to NPAT. What they can do is either direct all spare cash to debt paydown (which essentially delivers returns to equity holders via capital gains) or also provide some steady returns to equity holders via dividends (i.e. returns as income). If they choose the latter, they'll borrow to help fund that distribution. There's nothing inherantly shady about that, although its not sustainable to continuously increases the D/EV ratio to fund dividends. However, its possible to pay dividends while maintaining a constant D/EV or reducing D/EV over time.




Agree. Or like telstra did a while ago. Borrow money to pay divs...


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## cheeyeen (18 June 2009)

My understanding is that performance of some companies, especially companies that generates income based on hard assets (rentals etc) like property trusts and infrastructure companies like APA, are assessed based on cash earnings rather than the reported earnings.  Distributions/dividends are based on free cash flow (after accounts for all cash expenses like interest expenses, maintenance etc).  That's because depreciation on assets becomes a large part of the expenses.  The argument is that depreciation on assets doesn't affect current cash flow (because they are paid for already), though they have to budget for capital investment to maintain the assets (which will then be depreciation in the future).  So typically they will set their distributions based on free cash flow after all the budget capital spending require in the coming years.  (This is very much similar to the concept of positive cash flow property investment concept.  Your rental is enough to cover all the interest and other expenses.  But when you do your tax return, you actually have a tax loss after taking into consideration of depreciation on the rental property and use the loss to offset your current income, which then allows you to get some tax back from the tax office).

The main problem with a lot of the property trusts and infrastructure companies before was that their distributions are not based on free cash flow.  Rather they revalue their assets to show high profit (but u don't see the cash unless u sell it), and then borrow money to pay the distribution.  It worked when the credit market was easy and there is a market boom, but we have seen what happen when the market condition changed.

I think the banks also report cash earnings.  One area that I can think of is because of the provision for bad debt, which is not a cash expense now, but is a projection of loss that they will have in the future.  Again in the good time most people only checks the cash earnings.  Now the analyse looks at the headline cash earnings and reported earnings figures, then quickly go into details to find out the bad debt provision.  The provision can get complicate though as it is just a management view.  So depends on the managers, u might not get a true picture.


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## Fluffy (18 June 2009)

(This is very much similar to the concept of positive cash flow property investment concept.  Your rental is enough to cover all the interest and other expenses.  But when you do your tax return, you actually have a tax loss after taking into consideration of depreciation on the rental property and use the loss to offset your current income, which then allows you to get some tax back from the tax office).

I haven't got any rental property, but I would like to know more about the concept above this sentence. I didn't know you could do that...


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## cheeyeen (18 June 2009)

Fluffy said:


> (This is very much similar to the concept of positive cash flow property investment concept.  Your rental is enough to cover all the interest and other expenses.  But when you do your tax return, you actually have a tax loss after taking into consideration of depreciation on the rental property and use the loss to offset your current income, which then allows you to get some tax back from the tax office).
> 
> I haven't got any rental property, but I would like to know more about the concept above this sentence. I didn't know you could do that...




I know I wouldn't do a good job in trying to explain it as there are a few possible scenarios and things that you have to be mindful of.  (see.. people writes books about the concept).  You are better of get a property investment book (there are quite a lot of them) or do some good search for articles about positive cash flow property investments.


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## beamstas (18 June 2009)

The dividend can't be larger than earnings. Simple.
I can't pay you $5 if i don't have it.


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## Warren Greenspan (18 June 2009)

Fluffy

Margaret Lomas is a well known Australian author who has 3 or 4 relatively recent books on that exact topic, positive cash flow rental property via depreciation etc.

The books are $27 or so and are very easy to read.

Thanks for the answers people

Warren


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## Fluffy (18 June 2009)

I was interested because it sounds/seems like you can say that you have lost money (due to the house depreciating in value) and claim that loss against your income...something that can't be done with shares as they are paper losses...


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## Tysonboss1 (20 June 2009)

Warren Greenspan said:


> APA is a good case in point. WDC another.
> 
> I'm sure the explanation is obvious but it escapes me.
> 
> ...




A company can be making a cashflow profit Higher than their taxable profit, 

In APA's Case their reported taxable profit or in other words their "earnings", In less than the actual Cash flow profit because of all the depretiation they can claim from their massive infrastucture and annuity type investments.

Say they had total income of $10,000 and they had expenditure of $4,000. They would have a cashflow profit of $6,000 from which they can pay dividends. but if they claim $2000 in depretiation then it reduce their reported earnings to $4,000 how ever this is not a real cash loss so they still have $6000 to pay out at dividends.

This is also the case with alot of companies writting down the cost of assets, Sims report an earnings loss due to writting down the value of certain businness but still made a cashflow profit.


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## Tysonboss1 (20 June 2009)

Fluffy said:


> I was interested because it sounds/seems like you can say that you have lost money (due to the house depreciating in value) and claim that loss against your income...something that can't be done with shares as they are paper losses...




The way an investment property works is like this.

When you buy a rental property you are infact making two investments, 1, is the land itself and the other is the building.

The land will hold it's value and increase in value over time, But the building itself, while being essential to collect rent, goes down in value.

so if you buy a house for $200,000, the building is probally worth $130,000 and the land $70,000.

So you have paid $130,000 for the building which includes everthing from, Fences, driveways, Carpets, light fittings, paint, ovens, stoves, toilets, bathroom and kitchen fit outs, clothes lines, land scaping, aircon systems etc, etc.

You then pay a depriation expert about $350 to put together a depriation report which allows you to claim the cost of all the items I listed above over their life, the report normally runs for 40 years, with the amount you can claim decreasing every year.

For example, if you spend $2000 to put a drive way into an investment property you can not claim this as an expense all at once. you have to claim it over the life of the item claiming roughly 10% of it's original cost each year.

original cost $2000, you would claim $200 in year 1, $180 in year 2 $162 in year 3, etc etc till you have claimed the full $2000.

when you eventually sell the property, the capital gains tax is calculated somthing like this, 

Original pruchase price $200,000 minus $20,000 depreation claimed = $180,000 cost base.

Sale price $300,000 - $180,000 cost = $120,000 capital gain - 50% capital gain discount $60,000 Taxable capital gain.

So claiming depriation does result in a higher capital gains tax in the future, however It does give you some extra $$$ to offset your neg cashflow and because of the cap gain discount of 50% you only have to pay back 50c of every dollar you claim, and you don't have to pay it back for years into the future when you eventually sell.


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## akkopower (5 April 2010)

Tysonboss1 said:


> original cost $2000, you would claim $200 in year 1, $180 in year 2 $162 in year 3, etc etc till you have claimed the full $2000.




So how long will it take to claim the full $2000?


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