The last post in this series discussed dividend yield and dividend growth rate. This post will address the payout ratio. The payout ratio is a bit of a crude implement, but it is a quick and useful way to gauge at a high level the safety of a company’s current dividend and the prospects for future dividend raises.
The payout ratio is simply the current dividend divided by earnings, being careful to look at the same time frame for both. For example, if a company paid out $1.00 in dividends per share in the full year of 2012, and had earnings of $4.00 per share in 2012, the payout ratio for 2012 is $1.00 divided by $4.00, or 25 percent. If the company paid out $3.00 in dividends against $4.00 in earnings, the payout ratio is 75 percent. If the company paid out $5.00 in dividends against $4.00 in earnings, the payout ratio is 125 percent.
Why is this number useful? Obviously, a company cannot return more money to shareholders than it earns for more than a short period of time. Dividends are paid out of earnings, and so earnings are a sort of ceiling on dividends. While this is not absolute – a company can finance dividends with debt or savings for a time – in the longer term, the earnings have to be there for a dividend to be sustained.
A company with a low payout ratio has room to grow the dividend without getting ahead of current earnings. A company with a high payout ratio has less room to maneuver in growing the dividend – there are less excess earnings to draw on to do so. Less intuitive is the fact that regardless of the payout ratio, if earnings are growing over time, the dividend can grow commensurately. As a very general matter, a lower payout ratio provides some comfort that the company will be able to maintain and grow the dividend, especially where there is also consistent earnings growth.
Some dividend growth investors have hard rules about the payout ratio, such as not investing in any company with a payout ratio above 70 percent. While I think the payout ratio is a valuable metric, in my opinion it should not serve as the basis for hard and fast rules. What is a good payout ratio for one company may not be good for another. I would be very uneasy with a payout ratio of 80 percent for Intel (INTC), for example, while I am very comfortable with a payout ratio of 80 percent for Altria (MO). (In fact, MO specifically targets paying out 80 percent of earnings as dividends.) On the other hand, I wish that Aflac (AFL) would increase its payout ratio a bit, giving shareholders back a bit more of earnings.
At the end of the day, commitment to future dividends and dividend increases cannot be communicated through the payout ratio alone, but payout ratio tells you a lot about sustainability of the dividend and the ability of the company to keep growing the dividend at a good pace.
Next up, I’ll post about earnings growth.
The payout ratio is simply the current dividend divided by earnings, being careful to look at the same time frame for both. For example, if a company paid out $1.00 in dividends per share in the full year of 2012, and had earnings of $4.00 per share in 2012, the payout ratio for 2012 is $1.00 divided by $4.00, or 25 percent. If the company paid out $3.00 in dividends against $4.00 in earnings, the payout ratio is 75 percent. If the company paid out $5.00 in dividends against $4.00 in earnings, the payout ratio is 125 percent.
Why is this number useful? Obviously, a company cannot return more money to shareholders than it earns for more than a short period of time. Dividends are paid out of earnings, and so earnings are a sort of ceiling on dividends. While this is not absolute – a company can finance dividends with debt or savings for a time – in the longer term, the earnings have to be there for a dividend to be sustained.
A company with a low payout ratio has room to grow the dividend without getting ahead of current earnings. A company with a high payout ratio has less room to maneuver in growing the dividend – there are less excess earnings to draw on to do so. Less intuitive is the fact that regardless of the payout ratio, if earnings are growing over time, the dividend can grow commensurately. As a very general matter, a lower payout ratio provides some comfort that the company will be able to maintain and grow the dividend, especially where there is also consistent earnings growth.
Some dividend growth investors have hard rules about the payout ratio, such as not investing in any company with a payout ratio above 70 percent. While I think the payout ratio is a valuable metric, in my opinion it should not serve as the basis for hard and fast rules. What is a good payout ratio for one company may not be good for another. I would be very uneasy with a payout ratio of 80 percent for Intel (INTC), for example, while I am very comfortable with a payout ratio of 80 percent for Altria (MO). (In fact, MO specifically targets paying out 80 percent of earnings as dividends.) On the other hand, I wish that Aflac (AFL) would increase its payout ratio a bit, giving shareholders back a bit more of earnings.
At the end of the day, commitment to future dividends and dividend increases cannot be communicated through the payout ratio alone, but payout ratio tells you a lot about sustainability of the dividend and the ability of the company to keep growing the dividend at a good pace.
Next up, I’ll post about earnings growth.