The Most Important Dividend Metric in Difficult Times

I was laying in bed thinking of this day and age, the performance of companies and how critical attributes are in determining what is the absolute most important metric for a dividend stock you own.  I began reviewing the list of stocks that I currently own, you name it – Procter & Gamble (PG), Johnson & Johnson (JNJ), AT&T (T) and other big dividend aristocrats and I finally saw the trend of what made my stomach feel uneasy and what made it feel comfortable.  That metric was the payout ratio.

The most important dividend metric in difficult times – The Payout Ratio

How did I come across the payout ratio?  Well, first off – it is one of the screening filters in the dividend diplomat stock screener, but that’s not exactly how I landed on this conclusion.  It’s actually a combination of sorts – experience, performance and safety – that allowed a conclusion such as that to form.   There are a few intricacies to this payout ratio, but let’s provide a terminology for the readers.  Your payout ratio is…

Total Dividends Paid / Total Net Income   OR   $Div Per Year/EPS

 Simple enough right?  Now, I’ve seen payout ratios all over the place from 0% to well over 100% (which is the danger zone); as well as even negative percent (which is territory that just doesn’t make sense… when you have net losses and you’re paying a dividend…).  Then, from our preferred range we have the sweet spot at roughly 40-60%, which essentially breaks down to – the company keeps close to half of their earnings and pays out half to the shareholders.  Bottomline – we’ve seen it all.

Next, I’d like to ask this – How many investors, shareholders and others have seen the their companies struggle to keep up with earnings?  How many have cut expenses so much that there is nothing left?  How many are having difficulties with also top-line revenue?  I’ve seen more and more of that, with Apple (AAPL) being a great example.  I wanted to do a little more research and online I found the average Earnings per share by year for the S&P had hit a peak on 12/31/14 and then declined down to 87.12, which is lower than what it was at 12/31/11… aka the earnings has slid a bit and are not as strong – giving prompt to why I feel the payout ratio is such an important dividend metric, during economically difficult times (insert.. OIL).  Please see the chart of EPS by year from this website: http://www.multpl.com/s-p-500-earnings/table

S&P earnings

Think of all the crisis that are occurring around the world right now.  Oil.  Isis.  Zika.  Elections.  99% vs 1%.  Every single crisis is having dramatic impacts on industries and earnings.  The proof is in the pudding.  Further, I even received a report from this site (one of my favorites now): http://www.factset.com/websitefiles/PDFs/dividend/dividend_3.16.16; to which in it, it reads:

payout ratio 12.31.15 report

As you read in the 2nd sentence – the dividend payout ratio in their Q4 analyzed (which is ending 1/31/2016) increased 15.4% YOY!  WHOA.  Why?  Earnings are down, and that makes sense.  Further – the opening to sentence one brought it right out of the book.  The S&P 500 ratio is fairly safe, though, at 38%.  

Experience with the Importance of the Payout Ratio

Now – theory and literature is great, but how about from experience?  Well it doesn’t take more than Bert to tell you about my analysis of FirstEnergy (FE) (a reason why Bert is debating on selling the stock) back a few years ago.  Their earnings were slumped, and operating cash flows were way too tight.  I told him and a few others – a dividend cut has to occur, as the payout ratio far exceeded 100% and exceeded it for far too long.  It wasn’t until a few weeks later and in early 2014 – boom, dividend was cut.  Obviously with the oil & commodity prices, I don’t even have to tell you about the misery with Kinder Morgan (KMI) and shortly thereafter – wonderful BHP Billiton (BBL).  And guess what?  payout ratios still explode through the roof with the biggest oil player in Exxon Mobil (XOM), with no cuts but then the cut occurred with behemoth Conoco Philips (COP) back in February.  I have learned from experience that a safe payout ratio is key and critical to a dividend investor, without a shadow of a doubt.  My forward income was slashed in the hundreds from this… picture if you were someone who had previously generated thousands from the dividend stream?  O U C H.

Why is this so important?  Because – with dividend entities that have a nice solid growth rate, which we do love, they need to watch out for the ceiling or the 100% payout ratio ceiling.  The closer you are to hitting your head on the ceiling, the more you ask the question – is this sustainable?  Can the dividend not only be paid but can they still continue with the increase?  With the diplomat screener of between 40-60%, for sure, but earnings can derail fairly quickly to cause the ratio to sky rocket.

Examples of recent purchases that have more safety to them then meats the eye:  When we purchased T. Rowe Price (TROW) a few months back, they were at roughly 47% and then with Archer Daniels Midland (ADM) recent purchase in January, the payout ratio was mid 30% range (36%).  They can sustain earnings hits, while maintaining and even raising their dividend at a lower rate than usual.  Then… when performance is better than normal – growth can return to a more normalized level.

Conclusion & Summary on the payout ratio

As you can see from above – I am falling more into the payout ratio screen.  I believe as a dividend investor during these troubled earnings times, it is ever so critical.  The oil crisis that we are going through now has shed more light on that than ever, and it’s a learning lesson we can all take.  What does everyone think of the payout ratio?  Do you have a set range you look for?  What is too high for you?  Do you have too low of a point?  Also – any experiences to share?  Thank you again for stopping by everyone, looking forward to the comments and as always – happy investing.

-Lanny

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14 thoughts on “The Most Important Dividend Metric in Difficult Times

  1. I like to look at payout ratio in terms of FCF instead of earnings. Dividends are a cash expense; it just makes sense to me to analyze them in terms of the cash flow statement. 60% is a pretty good limit. You get much higher than that, and the company is probably not investing enough back into itself without adding to debt.

    I actually use a kind of convoluted “dividend cushion” calculation that’s very conservative. It takes net cash position into account as well as cash generation and dividend growth rates. You could have a 5% payout ratio and still fail the cushion test if your net cash position is too weak (too much debt).

    I appreciate EPS payout ratio for its simplicity though. It’s right there on the stock’s info page. Basing it on cash flow takes some extra digging. But I do that digging anyway so I don’t really mind.

    • Catfash,

      I can agree here – looking at the cash flow statement is critical and important as well in the analysis. Of course, the digging is fun and if it’s in your routine of analysis, does make it easier. But to go in line with the “ease” of use with the payout ratio – of course – you can load up a ticker and perform a quick calculation, hands down. Either which way – we are reviewing to ensure that there is “cushion” or a sense of “safety” with the payouts! Loving it.

      -Lanny

  2. Thanks for the article Lanny. I agree with you and that’s why Payout Ratio is critical moving forward. Also, Diversification from many companies as well.
    Thanks for your thoughts and hope we continue to pick up the highest quality of companies moving forward. I’m done with crazy high yields…
    Cheers bud.

    • Hustler,

      You got it. Diversification is critical – think if you owned an entire oil portfolio – guarantee you may be re-thinking a one-industry focus, right? haha, but the payout is easy to see, to use and can tell a story fairly quickly about the dividend and also about earnings retention (aka JNJ has to be the most consistent company of all time in regards to that haha). No more high yields for me – I may touch in the 5% territory with a community bank, but that’s about it or a REIT – as others have been commenting about that. Thanks again DH, keep grinding and I will too over here.

      -Lanny

  3. Ciao Lanny,
    I use PR to screen dividend stocks, but I allow myself to have a few positions where the 60% is breached. First of all REITS. Then secondly there are some companies that maybe are going through a bad patch and see a PR rise, but if deem it to be just temporary then it’s ok to invest in them. I find that there is not just one metric to evaluating a company, but surely a high PR is an important one!
    ciao ciao

    Stal

    • Stalflare,

      I agree on the REITS front – as 90%+ of those earnings are flowing over to us and there are other financial metrics to use when evaluating the REITS. You can easily look up the historical payout ratio – AT&T is one of them, where they are always/consistently at above the 60% range, simply because of the mature business they are in, as an example. It’s funny, though, reading dividend sites (not blogs) that are really hammering away at the payout ratio and the shear $ of dividends being paid in 2015 and into 2016… very interesting!

      -Lanny

  4. Very nice write up, and some very good points. We also use the PR as one of the metrics for dividend stock selection, with the occasional exceptions (see Stal above). But with decreasing earnings as you noted in the table, the PR may become a more critical measure for the selection of stocks in the short to mid-term.

    • CF,

      Thank you very much. The earnings trends are a bit scary when you look at it on an overall market basis – earnings on average are declining with rising dividends aka, the squeeze on payouts will continue. However, I need to do more research on history to see when the payout ratios were at these points and what the market ended up doing in response. Many metrics, but this is an important one for us div investors!

      -Lanny

  5. PR is a good metric to measure dividend stocks in difficult times. But the basic PR calculation isn’t good for REITs, you’d need to look at their financial reports and calculate the payout ratio by dividing distribution/unit by FFO.

    • Tawcan,

      Thanks for pointing that out. The FFO figure is definitely used for REITs, you’re spot on. I like reviewing the PR for a few periods to see how it’s trending, and lately, most entities are pointing “Up”, as earnings hasn’t kept up with increasing dividends or even a stable dividend. It’s been an interesting year and a half, that’s for sure.

      -Lanny

  6. I believe you have the makings of two articles here – Payout Ratio and Earnings (top vs. bottom). Although interrelated, to directly compare the two is misleading. Earnings per share can be manipulated through buybacks. Commodity pricing and economic conditions (domestic and worldwide) are other factors. Then you have the issue of Y/Y actual vs. analyst expectations (a news show staple).

    The other half, PR, is a reflection of earnings with a twist – the ability of management to accurately forecast and navigate through tough times. An incorrect assumption or flawed execution increases the ratio. Then there are activists agitating for increasing returns – Stillwell, Seidman, Basswood operate in your arena – also impact the ratio. Low interest rates, Cash on hand, expense controls, competition, industry and technology all play a part.

    Just saying, to focus on one metric – although an important one – is like trying to ride a bicycle blindfolded.

    • Charlie,

      I would agree – never focus on one ratio – but for a dividend investor I could make the argument for the payout being critical – as a high one for a non-reit entity, may point to unsustainability for a dividend. What impacts earnings? You listed it all out – expense controls, currency translation, R&D, etc.. Earnings is important and of course – can be manipulated using debt or cash to buy back shares to boost up the EPS figure, couldn’t agree more there. I love the analyses and debate about metrics to review for your screener and this is definitely one of them. Also – definitely don’t ride a bicycle blindfolded!

      -Lanny

  7. Hey Lanny,

    Definitely agree – the PR is very important. In Australia companies generally have higher payout ratios on average than our international cousins (due to a variety of factors, one being franking credits). It’s an important one, I think an increasing PR is worse than a high one, as that shows deterioration of some sort.

    Tristan

  8. I now use the payout ratio + the cash payout ratio (based on cash flow). It helps showing if the company has money in its bank account or not.

    But for me, the most important metrics of all is the dividend growth rate. If the company can’t increase its dividend during difficult time, it’s not good enough for my portfolio.
    Cheers,
    Mike.

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