The Payout Ratio
Along with the dividend yield, which tell you how much a company pays you now, and the dividend growth rate, which tells you how much a company will pay you in the future, there is one more important attribute to any dividend stock. How reliable is the dividend? A company is not required to continue paying the dividend so we need some measure of how sustainable the dividend is. For this, we'll look at the payout ratio.
To determine the sustainability of a dividend we need to determine how much of a company's profit is being used for the dividend. A company's dividend comes out of after-tax profit, known as the net income. When expressed as a per-share quantity this is called earnings per share or EPS. The problem with using net income in our calculation is that net income is an accounting number, used for tax purposes. Often, net income is not truly indicative of the true profitability of the company. A better quantity to use is either the free cash flow or the owner earnings. These numbers represent the cash flow of the company, and it's this cash flow which the dividend is directly paid out of. In the examples below I'll use free cash flow for convenience, since this quantity is readily available on a company's cash flow statement. The formula for the payout ratio is straight-forward:
The payout ratio is simply the total dividends paid within a period divided by the free cash flow from that period. This tells you what fraction of the free cash flow goes toward dividend payments.
Let's look at two fictional companies and analyse their dividends.
XYZ operates in an mature, stable industry. The company has been paying a dividend for decades and has a history of increasing the dividend payment each year. The stock yields 2.8% and the dividend has grown at an average rate of 6% per year over the last decade. The company's payout ratio is currently 40% and has not deviated considerably from this value over the last decade.
ABC operated in a volatile, cyclical industry. The company started paying a dividend just five years ago. The stock yields 5.2% and the dividend has grown at an average rate of 12% per year over the last five years. The company's payout ratio is currently 80%, but had fluctuated wildly over the last five years, exceeding 100% in some.
Which company offers the better dividend? XYZ offers a lower yield and past growth rate than ABC, but it also offers rock-solid stability. A company with a long history of both paying dividends and increasing dividends is likely to continue this trend. XYZ also offers a low payout ratio of just 40%, meaning that dividend growth can come from both growth in earnings and growth in the payout ratio. This also means that in a recessionary environment XYZ has a cushion protecting the dividend. If profits are suppressed the company can still support its current dividend payment. A dividend cut or dividend suspension is bad news for a dividend investor.
ABC beats XYZ on both yield and past growth rate. If both could be maintained ABC is clearly the winner. However, a high payout ratio of 80% and volatile cash flows means that their is substantial risk of the dividend being cut, unless the company has a large pile of cash on the balance sheet to maintain the dividend payments. Dividend growth for ABC can only come from earnings growth since the payout ratio is so high, and any sustained earnings decline would almost inevitably result in a cut or suspension of the dividend.
Since dividend investing is inherently a long term proposition, the safety of XYZ's dividend seems much more appealing than the high flying yield of ABC. You'd receive more cash now from ABC's dividend, but you'll most likely suffer crippling dividend cuts in the future. Your nice 5.2% yield could very well be slashed to nothing. In this case the extra risk taken on for a higher yield is almost certainly not worth it.
Beyond just yield and dividend growth, the payout ratio allow us to judge the sustainability of the dividend. A high yield is useless if it can't be maintained; a better strategy is to look for stocks which offer sufficient yield, consistent growth, and a low payout ratio.