Dividend-hungry investors tend to look for the best yield they can find. It can be dangerous to get too greedy, as high yield – a big dividend relative to share price – often means taking on lots of risk.
But experts say it’s wise to look at another gauge as well: dividend payout ratio, the percentage of earnings paid as dividends. The higher the figure, the greater the risk the company won’t be able to avoid a dividend cut if things go wrong. In extreme cases, firms pay out more than they earn, a red flag signaling the need for a deeper look to determine if it is a freak event or a sign of trouble like tumbling earnings.
But payout ratio is not a perfect gauge, either, and ought to be viewed in light of the firm’s overall performance, says, As’Ad Gourani, CEO at AG Wealth Management in Ann Arbor, Michigan.
“Although the payout ratio could be a very useful tool to look at when picking a company, it’s very important to look to put this gauge in the bigger picture and analyze their balance sheet to determine the sustainability of the payments, volatility of their earnings and the consistency of their cash flows,” he says.
On the surface, dividend payout ratio is simple. If a firm earns $1 a share and pays out 50 cents over a year, the ratio is 50 percent. A lower ratio suggests the firm earns enough to keep up those payments, or to raise dividends over time even if earnings are uneven. That can be especially important for investors who need dividend income and want it to grow to offset inflation.
Obviously, a firm paying out more than it has earned probably cannot keep it up forever. Paying more than 100 percent of earnings means the firm is borrowing to do so to keep shareholders happy, or is drawing on cash it could need for an emergency or other investment. A ratio over 100 percent is acceptable only if earnings had taken a hit from an unusual event that doesn’t reflect the firm’s overall health, like a lawsuit judgment or acquisition expense.
“A reasonable payout ratio range is around 40 percent, which is realistic when searching for dividends that are sustainable with good growth prospects,” says Craig Bolanos, CEO of Wealth Management Group in Inverness, Illinois.
“A payout ratio that is around 80 percent is considered high. A company with a high payout ratio is generally on the cusp of declaring most or all the money it makes as dividends. The risk of the company cutting its dividends significantly increases.”
The overall figure can mask a lot of details that deserve scrutiny.
How does the ratio compare to the firm’s peers? Some industries tend to pay out more than others and also enjoy steady revenues, such as utilities.
“Lower payout ratios can also be very good, since that leaves a lot of room for attractive dividend increases in the future,” Bolanos says. “However, too low and the company may not have a culture of being shareholder friendly.”
A ratio around 40 percent can be a sweet spot, providing plenty of income for shareholders while still leaving a lot of cash “to reinvest in the company and keep the growth moving in an upward direction,” he says.
How are earnings calculated? “Core” earnings that exclude one-time events can be a clearer look at underlying health than earnings figures whipsawed by those special factors, for instance.
Payout ratio can serve as a warning of the need to look deeper rather than a simple red light, green light signal to investors to buy or sell.
Income-oriented investors prize a high payout ratio because it produces the biggest quarterly check possible. But a low ratio – or no dividend at all – isn’t necessarily bad. It depends on how the firm uses its income. Profits can be invested in research and development or expansion, to increase earnings and hopefully drive up share prices, for example.
Or earnings can be used to buy back shares, reducing the number in circulation to help push up the share price.
Most companies are loath to cut or eliminate dividends because that signals trouble, but a dividend cut may be a smart move if the firm has a better use for its profits, says Mark Painter, founder of EverGuide Financial Group in Berkeley Heights, New Jersey.
“While cutting a dividend is usually a last resort because of the stock price effects, dividends can be a large cash outflow for a company, and sometimes cutting a dividend is in the best long-term interest of the company and shareholders,” he says.
In fact, many growth-oriented investors prefer profits be used for reinvestment or buybacks, because investor gains from share prices are not taxed until after the shares are sold, while dividends are taxed in the year they are received.
So a stock with a low payout ratio may nonetheless be a good bet. If there is no dividend, or only a small one, investors who need income can sell some shares from time to time.
