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 a lot of risk.
Experts say it’s wise to look at another gauge: the dividend payout ratio, or the percentage of earnings paid as dividends. The higher the figure, the greater the risk the company takes as it 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.
There are several ways investors can use the dividend payout ratio that help reveal characteristics about a company like the state of its business or the phase of the business’ life cycle. Here’s what you need to know about this metric and how it can help you choose quality dividend stocks:
— What is a dividend payout ratio?
— How to calculate a dividend payout ratio.
— How to analyze a payout ratio.
[Sign up for stock news with our Invested newsletter.]What Is a Dividend Payout Ratio?
A dividend is a payment from a company’s stock to its shareholders that’s usually paid out every quarter. It represents part of the company’s profits that shareholders are entitled to for holding the company’s stock.
“Dividends represent returns of excess capital generated by the business which are not needed for reinvestment growth opportunities in the future,” says Todd Lowenstein, equity strategy executive at The Private Bank at Union Bank in Santa Barbara, California.
“It’s a sign of confidence by management around a proven business model that produces high returns on capital and excess free cash flow,” he adds.
The dividend payout ratio (DPR), or simply the payout ratio, is a measure of how much of a company’s net income is paid out to its shareholders as a percentage of the company’s total earnings. DPR is an important metric for investors to use when assessing the stability of a company’s profits and, of course, its dividend.
How to Calculate a Dividend Payout Ratio
On the surface, the dividend payout ratio is simple. If a firm earns $1 a share and pays out 50 cents over a year, the ratio is 50%. 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.
The way to calculate the payout ratio is by dividing a company’s total dividends by its net income. For example, if Company ABC reported a net income of $80 million and total dividends of $35 million, its payout ratio would be about 43%, a fair payout ratio.
“A higher payout ratio is a sign of a strong balance sheet, and we find companies with a 35% to 55% payout ratio attractive and a sign of stability,” says James Demmert, founder and managing partner at Main Street Research in Sausalito, California.
A payout in this range allows a company to continue to pay shareholders and reinvest in its business while growing its dividend. As a dividend investor, you want to own a stock where the dividend grows overtime. A DPR within this standard range can help maintain dividend increases.
Investors focused on income, may look to more established companies that have a consistent dividend payout history, like the dividend aristocrats. The aristocrats are a group of S&P 500 dividend stocks that have 25 years or more of consistent dividend increases. These popular dividend growth stocks include Coca-Cola Co. (ticker: KO), Procter & Gamble Co. ( PG) and AT&T ( T), among other well-known names.
“Income-oriented investors should seek companies with payout ratios in excess of 60% to maximize dividend yield over underlying company growth,” Demmert explains.
A firm paying out more than it has earned probably cannot keep it up forever. Paying more than 100% 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 of more than 100% 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, experts say.
[See: 7 of the Best ETFs to Buy for Long-Term Investors.]How to Analyze a Payout Ratio
The 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.
Many growth-oriented investors prefer profits to 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.
There is a difference between how startups or smaller companies treat their dividends and how larger, more established companies do.
If a company is in its growth stage, it may not be able to afford a higher dividend since it will likely reinvest most of its earnings back into the company. While companies at all phases may be focused on growth, a company whose business is more developed can distribute higher dividends to its shareholders.
“Generally, a low dividend ratio indicates that the company has enough earnings to support future dividend distributions or sustain a rising dividend payout, which is a good sign,” says Arvind Ven, founder and CEO of Capital V Group in Cupertino, California.
A high payout, Ven continues, runs the risk of the company not allocating enough funds for growth, innovation, and research and development, among others.
It can be helpful to look at a company’s earnings in tandem with evaluating its payout ratio. If a company’s earnings are increasing, it may be in a position to increase its dividend in the future.
Investors who see a consistent increase in dividends can indicate that the company is financially stable with more room for growth. For a company whose earnings may not be able to afford a dividend increase, the dividend may stay stagnant or worse, face a dividend cut.
Payout ratios can vary by sector. Utilities and consumer staples are known for higher dividend payout ratios because of their high earnings and reliable cash flows, whereas the technology sector tends to have lower payout ratios because reinvestment is required for growth and innovation.
[See: 9 Business Development Companies to Buy for Growth.]Takeaway
The key is to attract and maintain a company’s shareholders, and dividend increases are more of a reason for investors to hold on to a company’s shares for the long term. Monitoring the dividend payout ratio can help you understand the nature of dividend changes and what this may mean for the dynamics of the business.
