Investing in dividend stocks can be a very profitable way to grow your wealth. This could be done as a part of a value investing practice (Read: Why dividends are a value investor’s best friend), or it could be a strategy in itself. Regardless of why you invest in dividend paying stocks, it helps to understand the basic investment terms.We will look at the dividend payout ratio and why it is an important metric for value investors to consider.
Dividend Payout Ratio
This is the formula that determines how much of a company’s overall income goes towards paying shareholders. It’s a helpful tool to see how well a business is operating and if it has growth potential. All you do is take the total amount of dividends and divide it by the total net income to get the ratio.
Dividend Payout Ratio = [ Dividends Paid / Net Income ] = [ Dividends per share / Earnings per share ]
So what is the purpose of this metric?
- A reasonably high dividend payout ratio indicates a mature business
- A reasonably high dividend payout ratio indicates a management that is concerned about returning value to the shareholders
- A very high dividend payout ratio can actually indicate a business in trouble (net income has declined but the management does not want to cut dividend) or perhaps the management engages in downright dangerous financial engineering (such as borrow money to pay dividends)
Dividends for Income Investors
Income investors require sufficient income through dividends, and growth in dividend income over time that keeps pace with inflation or better. Therefore, income investors need to select reliable dividend paying stocks along with a dividend payout ratio that allows for future growth in dividends. Additionally, if you are investing so that you can enjoy the dividend income in your retirement, you need to ensure that the likelihood of a dividend cut or elimination is minimized. A well chosen dividend stock and a conservative dividend payout ratio can help you achieve this goal.
What is a Good Payout Ratio for Dividends?
A company’s dividend payout tells you a lot about the the financial stability of the company and the management’s orientation towards rewarding shareholders. Investors buy dividend stocks to generate income and they also want the dividend income to increase when the company does well. Too little of a dividend payout shows that the management considers that it can do a better job of growing shareholder wealth by investing in new projects (instead of paying higher dividends to the shareholders). Very often, rapidly growing companies choose this route. Most stable and consistently cash flowing companies choose to pay regular dividends to the shareholder as a way of sharing wealth.
For a growing company, dividend payouts can range from 0% to low single or double digit percent. For example, Apple Computers currently pays less than 20% of its net income as dividends. Amazon on the other hand does not pay any dividend making its payout ratio equal to zero.
A well established company tends to maintain its dividend payout to between 20% and 50%. This allows them to be generous to the shareholders and also leaves room to grow dividends in the future. If the business slows down temporarily, they can still maintain dividend payments without too much of a fuss.
Any time you see the dividend payout ratio to be higher than 50%, please pay attention and ask yourself why this might be the case.
There are certain situations when a high dividend payout ratio is not only acceptable, but also expected. For example, Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs) are required by law to return a significant portion of their earnings back to the shareholders as a dividend. Many Master Limited Partnerships (MLPs) could also sport a high payout ratio, specially when they are liquidating themselves, as majority of the payout can be in the form or Return of Capital, instead of dividend income.
If a non REIT/MLP or BDC company sports a very high payout ratio (over 50%), it is possible that the business is very stable and the company is confident of maintaining its market share.
On the other hand, it is also possible that the high payout ratio is a result of a significant decline in the earnings. If this is the case, and the company is not able to recover soon, it may have to cut or eliminate dividends to preserve cash. This needs to be carefully evaluated.
Dividend Payout as a Signal of Confidence in Future Earnings
A highly confident management pays a good dividend that grows as the company grows its earnings.
The very fact that a company pays a dividend works to engender confidence in investors. There are many ways to manipulate accounts, but there is only one way to pay a dividend – with cold hard cash. If nothing else, investors can consider existence of a dividend as a positive sign.
However, if a company has a long streak of consistent (or growing) dividend payments, it is a further indication that the management works hard to reward their shareholders. These are the type of stocks that income investors should hold long term for dividend income.
On the contrary, a dividend cut is almost always a bad sign that there are tough times ahead for the company.
Company Dividend Payout Policy
Each company manages its money differently, and this term refers to the set of rules and parameters that it has in place regarding how it distributes its dividends, as well as what rates it sets. This policy can be stable, constant, or residual, and each one affects how much investors can make.
- Stable dividend policies are the most common. These are designed to pay out the same amount each quarter, regardless of the price of the stock. Most investors like these policies because their earnings are not reflective of the market.
- Constant policies only pay a percentage of the stock price, which can fluctuate. This can be better for the company, but it can also be worse for the investor, so it’s not used very often.
- Residual policies are another one that benefits the company more than the shareholders. Usually, the dividend payout ratio is based on net income, but in this case, it would be based on the money that is left after the business pays off its capital expenditures.
In the end, dividends are a great way to earn a steady income from your stock, just be sure to do your homework and invest in the right companies and know where the dividend is coming from.
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