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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)
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.
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.