In a recent article, Lanny broke down what a dividend is and highlighted what is so great about receiving a dividend. When I first started learning about dividend investing, there were a lot of articles and emphasis on assessing a company’s dividend payout ratio. So I thought I would take some time today, provide a definition for the payout ratio, show how to calculate the metric, and some other details/tricks of the trade that we have picked up over the years as we continue to invest in dividend growth stocks.
What is the Dividend Payout Ratio and How Do You Calculate It?
The dividend payout ratio represents the percentage of a company’s earnings that is paid out in the form of dividends to shareholders. Here is the quick and easy equation to calculate a company’s current dividend payout ratio:
Here are a few examples to demonstrate how to calculation a company’s ratio. :
Let’s say that a company had EPS of $10/share last year. If a company has a $5/share annual dividend, the company would have a dividend payout ratio of 50%. If a company has a $6/share annual dividend, the company would have a payout ratio of 60%.
Since the dividend payout ratio is drive by the company’s dividends per share and earnings per share, the ratio will increase or decrease as a company announces changes to their dividend and reports earnings. If the company maintains their dividend for the year but reports earnings growth, the dividend payout ratio will decreases. Conversely, if EPS were to decreases, the company’s payout ratio would increase.
why a 100%+ Dividend Payout Ratio isn’t a good thing?
Thinking through the equation above, the dividend payout ratio represents the amount of the company’s earnings that are paid to shareholders. A 100%+ dividend payout ratio indicates that the company is paying out more than the company is earning in the current year. Thus, the company’s earnings are not sufficient to sustain the annual dividend paid to shareholders. In the long run, this is not a sustainable situation for a company. Eventually, the company would have to use their current retain earnings to cover the difference, thus reducing total equity.
There are only two ways that a company can reduce their dividend payout ratio in this scenario. One is positive and one is negative. First, the positive. if the company increases their earnings, their dividend payout ratio would decrease. So if a company pays an annual dividend of $11/share and had an EPS of $10/share, their payout ratio would be 110%. Let’s say that the company crushes it in the next year and records an EPS of $12/share, their payout ratio would decrease to 91.6%. This is still a high percentage, don’t get me wrong, but at least the company’s earnings would cover the dividend.
The only other option that a company has in this scenarios is the dreaded dividend cut. In that same example, the company could also achieve a 90% dividend payout ratio by reducing the dividend per share from $11/share to $9/share. This may be the right strategic move for the company in the long run as this would allow the company to retain cash and use the cash to improve their business; however, as a dividend growth investor, this is not the optimal option. That is why Lanny discussed in an older article this is the most important metric for dividend investors in difficult times. If an investor observes a company’s dividend payout ratio increase towards 100%, it could potentially indicate that a dividend cut is on its way.
How and Why Dividend Payout Ratios Vary?
When I began investing, I would ask myself “How do you know whether or not a company’s payout ratio is too high?” That is a great question and there isn’t necessarily a right or a wrong answer to this question. Over time, we have learned how to assess and gauge the reasonableness of a company’s payout ratio. So here are some tips and items we consider when performing our review.
Industry Matters. Some Industries Have High Payout Ratios and Some Industries Have Low Payout Ratios – Payout ratios come in all shapes and sizes. We use a 60% Payout Threshold in our Dividend Stock Screener to identify investments to consider. This is a general rule of thumb; however, we both own investments that exceed this threshold.
Why is that? There are certain industries where companies have higher dividend yields and dividend payout ratios. Some of the major industries that come to mind are diversified oil (XOM, RDS-A, BP, CVX, and TOT) , telecom (T and VZ), utilities, and REITS. In these industries, companies will pay shareholders a higher percentage of their earnings in the form of dividends. In fact, REITS are required by law to pay out a higher percentage of their earnings. So it is important when reviewing a company to compare their metrics to the competitors to gauge whether the payout ratio is in-line with the industry, or if their high payout ratio should cause you to perform a deeper dive with the company.
Similarly, there are industries that will have lower dividend yields and lower payout ratios. Growth companies typically fit this category, as they are using a larger percentage of their earnings to grow their business rather than pay a dividend.
Considering the Current Payout Ratio Compared to Historical Payout Ratios – If you are curious about a company’s payout ratio at a point in time and would like to determine if the payout ratio is higher or lower than the past, you can compare the current payout ratio to the company’s historical payout ratio. The beauty of public companies is that they are required to file financial statements quarterly, so there is a lot of historical information available at your finger tips. The company’s quarterly financial results (earnings release, 10-Q, or the annual 10-k) can be located on the company’s investor relations page or the SEC’s website (sec.gov).
When Comparing REITS, use FFO/AFFO rather than EPS – This is a tip for reviewing REITS (Real Estate Investment Trusts). While REITS are required to require to report EPS since it is a GAAP metric, the industry standard metric is FFO (Funds from Operations) and AFFO (Adjusted Funds From Operations). To calculate FFO, add back depreciation and gains/losses on sales of real estate to net income (while AFFO may include other adjustments). Management is required to provide a reconciliation from EPS to FFO in their quarterly filings since FFO is a non-GAAP metric, so an investor can find a REITs FFO/AFFO figures in their Form 10-Q and 10-K. Whenever I assess a REIT’s payout ratio, this is the metric I will use in the denominator rather than EPS. I included a link to a great article in Forbes providing further background on this topic.
If you are looking to become a dividend investor, understanding the dividend payout ratio is critical. Hopefully this article provided some background about the metric, how to calculate it, and how to evaluate a company’s ratio. Of course, there is so much to learn about the topic and there are other great tips out there. Unfortunately, I could not include them all in one article! So please, feel free to share how you analyze a company’s payout ratio in the comment section so we can all learn from each other.
-The Dividend Diplomats