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Dividend Investing 101
Michael McDonald Jul 13, 2017
Have you ever considered a stock based on a seemingly attractive dividend but felt unsure if the company could keep paying that dividend in the future?
If so, then the concept of a payout ratio is one you should keep in mind. Payout ratios help investors to determine if a firm’s dividend is secure and sustainable for the future.
The payout ratio is the ratio of a firm’s total dividends paid to all shareholders to its total net income. Alternatively, you can think about it as the dividend on a single share of stock divided by the earnings per share of the stock.
You can find an updated list of companies that recently announced changes in their payout policies along with their ex-dividend dates in our Dividend Payout Changes and Announcements tool.
Let’s imagine a company earns $2.00 per share this year and pays out $0.80 per share. The firm’s payout ratio is $0.80 divided by $2.00 or 40%.
Many firms adopt what is known as a payout policy, which simply tells shareholders that the firm expects to pay out some constant percentage of their earnings as a dividend. For example, a firm declares their payout policy to be an intention to pay 40-45% of profits to shareholders each year in the form of dividends. If the firm’s earnings grow to $3.00 per share over time, then the dividend should grow to a range of $1.20 to $1.35 per share.
Payout policies are important because they give investors the security of knowing what the company’s plans are for their earnings. Companies have to choose between competing uses of cash – they can either make internal investments with cash in an effort to grow their business or return cash to shareholders through dividends and stock buybacks. There is no single right answer about what use of cash is better – it depends on the company’s situation – but a payout policy helps shareholders to understand management’s thinking and plans for the future.
Learn more about dividend payout policies here.
Investors can use the payout ratio metric to decide if a stock is a good investment given their objectives. Not all firms pay dividends, of course, but some firms that do pay dividends may not have a secure dividend.
The average dividend payout ratio for the S&P 500, as of December 31, 2015, is roughly 57% according to Hartford Funds. In fact, the Hartford study also found that the companies with the highest dividend payout ratio are not the most profitable for investors. The data shows that in the Russell 1000, 20% of firms with the largest dividends had an average payout ratio of 67% since 1979. This is a risky-enough level that some of those funds end up cutting their dividends – a circumstance in which the markets generally react very negatively. In contrast, the next highest 20% of dividend payers (the second quintile) have an average payout ratio of 46%. And these second quintile of stocks – the ones paying a high but not extreme dividend – actually do better over time than other groups of stocks.
In addition, a payout ratio over 100% is not sustainable in the long run of course – a company cannot consistently pay out more to shareholders than they are earning in profit without eating into their asset base. Still, even payout ratios less than 100% can be problematic in some cases.
In general, any payout ratio above 60% should cause an investor to dig deeper into a firm’s financials, while payout ratios above 80% can be a red flag. The problem with high payout ratios is that a firm’s profits are typically much more volatile than a firm’s sales. If sales grow or shrink 5% year-over-year, then profits can often grow or shrink 15% or more in the same period. Thus, a small fall in sales can lead to a dramatic drop in profits depending on the economic scenario or industry-specific conditions.
Find out more about the payout ratios in different sectors here.
Put simply, a high payout ratio means a company is using a significant percentage of its earnings to pay a dividend, which leaves them with less money to invest in the future growth of the business. Toy company Mattel Liquid error: internal, which has a payout ratio of roughly 63%, is a good example of a firm with a somewhat elevated payout ratio. Check out MAT’s dividend history here.
Stocks with low payout ratios can be good investments for investors looking for growth in income over time. Apple (AAPL ) is a good example of this. Apple currently has a payout ratio of about 28% – there is plenty of room for this ratio to grow over time if the firm chooses to return more cash to shareholders.
Check out what the investors are currently most interested in by visiting our Most Watched Stocks Page.
The table below lists ten stocks from different industries along with their dividend payout ratios and their total annual dividend to give you a sense of what payout ratios commonly are.
|Company||Ticker||Payout Ratio||Annual Dividend||Price||Yield|
|Altria Group||(MO )||74.40%||$2.44||$73.69||3.31%|
|Kinder Morgan||(KMI )||76.90%||$0.50||$19.08||2.62%|
|Mattel||Liquid error: internal||63.20%||$0.60||$20.92||2.87%|
|Goldman Sachs||(GS )||16%||$3.00||$225.84||1.33%|
|Exxon Mobil||(XOM )||82.40%||$3.08||$80.16||3.84%|
Overall, while there are many points to consider when evaluating if a stock is a good investment, payout ratio is definitely something to keep an eye on. As the chart above shows, many fine companies have high payout ratios, but the higher the ratio, the harder it is for the company to sustain that dividend, and any dividend growth requires earnings growth.
Lower payout ratios leave more room for growth, but they are often accompanied by relatively low yields. Payout ratios also differ markedly by industry; so, it is important to compare a firm to others in its own industry. Keep these points in mind and you’ll be better able to evaluate the financial stability of potential investments going forward.