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.
Read: The 3 Metrics of our dividend stock screener, which includes the dividend payout ratio!
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.
Summary
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
Nice lesson here guys. A couple questions…
1)Do you use basic or fully diluted EPS when making the calc (I use basic)?
2)Do you always use GAAP earnings or do you use non-GAAP EPS measures? I try to stick with GAAP, but sometimes it just doesn’t make sense to (ie. the deferred tax adjustments due to the new tax code)
3)I also like to calculate dividends as a percent of free cash flow as a cross check since accounting earnings can have a lot of noise in them. I go back in forth in my head on which of the two denominators is most appropriate (cash or income). What do you think?
Tom
Thanks Tom! Much appreciated. Great questions, let me know what you think!
1) Typically there isn’t that big of a difference between the two when I look at a stock. I’ll stick with Basic, but if there is a large disparity, of course I will consider it.
2) I’m an auditor, so I will always use prefer GAAP metrics haha But, there is always a time and place for non-gaap metrics and will consider them when analyzing a stock. I agree completely, there are times when you have to adjust GAAP and you highlighted some great examples. There are also one-time transactions costs (mergers for example) or earnings due to a large security gain/sale, that clearly aren’t recurring and shouldn’t be considered goign forward. With that being said, I’m cautious with adding too much back. I know some non-GAAP metrics will essentially add back the entire income statement to arrive at “adjusted earnings.” So I always advise people to be careful when adding them back into the equation.
3) I don’t see why you can’t consider both. There are certain cases when free cash flow should be used. But again, I would always be cautious like with number two. A lot of the noise is the proper accounting, so it always concerns me when too much is getting out. But the cash flow statements can tell a lot about the company. If I had to pick, I still would use EPS.
Let me know what you think!
Bert
Hi Bert. I think we see it in a similar light. Not surprising with both of us being accountants/auditors. And being accountants, I think we both are saying to some degree you need to get behind the numbers and use some judgement. Any scripted cookie cutter approach may not apply to every company every time for dividend analysis purposes. Thanks for your thoughts. Have a great weekend. Tom
Nice article guys! Very helpful for someone who is starting out and learning about dividend stock investing. Next article, yield on cost? 😉
As for us, we like to see the payout ratio at or below 60%. We feel there is more room for dividend growth (or a free raise!) when the yield is in that range.
Again, great article, Thanks for sharing. AFFJ
Thanks AFFJ – Much appreciated. YOC may not be the next one, but that would be a fun topic to write about, wouldn’t it? It is a fun metric to track and one that is definitely underappreciated. You highlighted exactly why we love the 60% mark.
Bert
Good read! I focus more on Free Cash Flow per share (instead of EPS) in relation to the dividend. I want to be sure that a company comfortably covers the dividend and has ample cash to reduce debt if necessary.
FCF, its growth over time and a high cash conversion rate can make me feel comfortable despite a relatively high debt level. Just take cash machines like Reckit Benkiser or Imperial Brands for instance having the ability to deleverage pretty comfortably AND increase their dividends.
Thanks for the detailed overview, Bert. I’d only incorporated a few basic elements into my crude selection criteria for the extensive – i.e., two – individual holdings in my current portfolio. This one is absolutely getting added. – Mike