Entry Criteria: Payout Ratio

[Kerim]

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.

[bobbyboy1970]

This is really helpful. I find the specific examples you're giving the most helpful part. Can you explain a little better why you say what you said about intel, mo, and aflac? Seems like a set rule about not getting into a stock wioth a payout ratio above a certain level would be more simple. Thanks!

[KeithD]

One of the problems I have always had with a company like Intel is that the No.1 position in the market changes every few years with its main competitor. In this case AMD, and this can effect the share price.

Intel are currently the market leader as the processors have about a 10% advantage on speed over AMD chips, but AMD are moving towards cheaper 8-core CPU's, so if they increase the speed by 5% then the price will per unit will make the other 5% irrelevant in the competition stakes.

However both these companies are starting to struggle as the ARM CPU is used in many smartphones and tablets, which is what people are buying and sales in PC's are dropping. Bot chip makers need to get decent mobile chips out to compete.

I wouldn't invest in either of these companies until the market clears up in a few years.

[Kerim]

(03-27-2013, 03:07 PM)bobbyboy1970 Wrote: Can you explain a little better why you say what you said about intel, mo, and aflac? Seems like a set rule about not getting into a stock wioth a payout ratio above a certain level would be more simple. Thanks!

As KeithD very rightly pointed out, Intel is in a rough industry -- change can come quickly and without warning in the tech space, and a leading company today may be left in the dust tomorrow. I happen to think that Intel is going to be just fine (it is one of my larger positions), but still, I like the margin of safety that a lower payout ratio provides for a company like that. It gives the company some flexibility and free cash flow to use as needed to keep pace in a volatile market. More importantly, it says to me that they will be able to continue paying, and increasing the dividend through the potential ups and downs they'll face in the market.

Altria (MO), on the other hand, operates in a much more stable business environment. Sure, commodity prices can fluctuate, and tobacco companies face constant threat and pressure from litigation, regulation, and laws designed to discourage smoking. But these are headwinds that are well known, well understood, and that can be priced into the stock. MO is a mature and stable company with a much more predictable cash flow. In a case like this, I am comfortable with a higher payout ratio. As I mentioned, MO specifically targets a payout ratio of 80 percent. I'm not worried that MO might need the cash for other things, and when MO does need to change course and respond to the market, it should require the same kind of capital that an Intel might need.

In Aflac's case, I'd like to see them increase the rate of dividend growth some, as the percentage of earnings paid to shareholders is on the low side -- below 25 percent. I think AFL is a well-managed company, and they may be using the cash to stabilize or improve its investment portfolio or in other ways that I do not understand. But given the low payout ratio, recent increases have felt stingy to me.

If you are just getting started investing in DG stocks, a firm rule about not investing in stocks with a payout ratio above a set limit might be useful to keep you focused on safe or conservative stocks that should form the core of your DG portfolio. Once you are more comfortable and are looking to diversify your holdings, such a rule might keep you away from great stocks like MO.

[Kerim]

(03-28-2013, 04:06 AM)KeithD Wrote: One of the problems I have always had with a company like Intel is that the No.1 position in the market changes every few years with its main competitor. In this case AMD, and this can effect the share price.

I wouldn't invest in either of these companies until the market clears up in a few years.

I agree that it is a fast-moving industry, and I certainly keep a much closer eye on my INTC than I do on, say, my JNJ, MO, or PG. But if you wait until the market clears up, you might miss out on some great opportunities!

[KenBob]

I have been burnt with dividend cuts by companies where the payout ratio has been high.

I don't buy any stock with a payout ratio greater than 0.80. In addition, my sell criteria puts heavy emphasis on payout ratio. I sell if the payout ratio gets above 1 or if the payout ratio is above 0.80 and the earnings growth rate is large negative number.