Visiting the Basics of the Dividend Payout Ratio
Can your stock earn enough to pay its shareholders?
Can it retain enough to continue re-investing?
The question I want to explore is, what could threaten your dividend payout?
There’s a lot of value topics at old school value, but not a lot of focus on dividends. It’s never too late to start.
Dividend Payout Ratio Basics
Going back to the basics, a shareholder can achieve returns in two ways.
- Capital appreciation
- Receiving dividends
If you buy a stock to receive dividends, the number one focus in on the reliability of the dividends being paid out today and going forward. Growth isn’t the most important objective here.
That’s where the dividend payout ratio comes in.
Here’s how you calculate it.
Dividend Payout Ratio = Dividends Per Share / EPS
Dividend Payout Ratio = Dividends Paid / Net Income
Determining what the “best” dividend payout ratio is subjective. However, here are some quick guides.
A low dividend payout ratio means that the company is reinvesting it’s net income back into the business to grow.
Conversely, you will see a higher dividend payout ratio from mature companies where they return capital to shareholders.
I say this is subjective because what if a growing company has a high dividend payout ratio? In order to pursue growth, the dividend may be reduced or canceled.
Basic Dividend Stock Characteristics to Look For
There are lots of possible fundamental points to discuss in this section, but that’s for another time.
From a very high level, what kind of company can retain profits handily and pay higher dividends to shareholders?
- A fast growing company (up for discussion)
- A company in a growing industry
- A mature company with consistent cash growth
One month ago, a report came out from FactSet showing that more companies are paying dividends. In fact, the percentage of S&P500 companies paying a dividend is at the highest level recorded in the past 15 years.
More interesting is that the payout ratio for mid and small caps is at multi-year highs.
It’s still not as high as it once was, but the following chart is interesting to note.
Here’s a free screen to look up companies based on their dividend payout ratio.
I grabbed a list from the site of the company names starting with A just to see what type of companies they are.
Despite all the cash that AAPL has, it only has a payout ratio of 6.
Also, check out the names with a payout ratio between 50-80.
A small sample size, but mature companies have a higher payout ratio.
Dividend Cuts – 4 Simple Warning Signs to Look For
Unfortunately, dividends are not a sure thing. It’s not a guaranteed income stream. There are going to be times when a company cuts their dividend.
Here are 4 simple warning signs that a company is en route to a dividend cut
- Decreasing and inconsistent profits – A company can still pay dividends if it has one or two bad years, but if profit continues to drop, watch out.
- Earnings is not enough to cover dividends – Watch for revenue trends, profit margins and other profitability factors. Would JC Penney give a dividend now?
- Low or negative FCF – Dividends should always be covered with FCF. Beware of stocks that take on debt to pay dividends.
- Higher than average Dividend Yield – Chasing yield can be dangerous. When the stock price falls, the dividend yield increases and can make it look tempting. This is a case where you should calculate the dividend payout ratio instead to determine whether the dividends can continue.
Examine but Don’t Panic Yet
Every company goes through tough periods. Even Apple is considered to be struggling.
Just don’t mistake it for a sign that dividends will be cut. A dividend is one of the last things a company will cut because it is directly associated with the stock price.
Any company that cuts their dividend will see a steep drop as dividend and income investors sell out.
Doing a quick dividend analysis isn’t rocket science. Even my basic math skill is enough to calculate and track it.
How do you use the dividend payout ratio?