Dividend Payout RatioThe dividend payout ratio is one of the most informative and popular metrics used to analyze the safety of a company’s dividend.

 

However, many investors do not realize the number of different ways that dividend payout ratios can be calculated and the other factors that should be considered when assessing the safety of a dividend.

 

Gaining an understanding of the dividend payout ratio can help income investors make better decisions, avoid riskier dividend stocks, and improve the quality of their portfolios.

 

What is a Dividend Payout Ratio?

Simply put, a dividend payout ratio reports the proportion of a company’s profits that are paid out as a dividend to shareholders. Income investors like to review a company’s dividend payout ratio because it serves as an indicator of how safe a dividend payment is and how much room there is for management to grow the dividend.

 

The idea behind the dividend payout ratio is that a business can only continue paying and growing its dividend if it is making enough money to support it. If earnings are not high enough to cover the dividend, the company needs to use cash on hand, raise debt, and/or issue equity to make ends meet.

 

If financing is not available and cash is running tight, the dividend will be cut well before the company risks missing a debt payment or damaging its business operations. Monitoring a company’s dividend payout ratio helps investors monitor the risk profile of their income.

 

How to Calculate a Dividend Payout Ratio

The most basic way to calculate a dividend payout ratio is to add up a company’s paid dividends per share over its last four quarters and divide that amount by the company’s total diluted earnings per share reported over that same period.

 

To use a basic example, suppose Coca-Cola reported earnings per share of $1.25, $1.00, $1.10, and $1.05 over its last four quarters while paying out total dividends per share of $3.20 (80 cents per quarter) during that time period.

 

Adding together each quarter’s earnings per share results in total earnings of $4.40 per share. If we divide Coca-Cola’s total dividends paid over that same period by its earnings, we get a dividend payout ratio of 73% ($3.20 per share in dividends divided by $4.40 per share in earnings).

 

Believe it or not, there are actually several different ways to calculate the dividend payout ratio. The various methodologies primarily differ in how they measure a company’s profits and the time period that is used.

 

Some of you might be wondering how profits can differ from one payout calculation to the next. Earnings are earnings, right? Not exactly…

 

Many companies actually report two different earnings figures each quarter. One set of earnings follows the Securities and Exchange Commission’s requirement that publicly traded companies follow Genearlly Accepted Accounting Principles (GAAP) for their financial reports.

 

Some companies choose to also present non-GAAP financial results. Non-GAAP results are usually reported to adjust out “one-time” events such as restructuring charges and non-cash impairments. When applicable, companies report non-GAAP figures in an effort to give investors a more “representative” look at their actual operations by excluding accounting “noise.”

 

There is much debate over using GAAP or non-GAAP figures. In some cases, non-GAAP results are a better look at the actual business. In other cases, investors wonder if a company that repeatedly makes adjustments to present smoothed out results is potentially taking advantage of non-GAAP reporting – “one-time” charges are not always as infrequent as their name suggests they should be.

 

For the earnings payout ratios found using our Stock Analyzer, we sum up a company’s total dividend payments and reported diluted earnings per share over the last 12 months. While they can occasionally create legitimate accounting noise, we use GAAP earnings to calculate our payout ratios.

 

As conservative investors, we figure that the small pool of blue chip dividend stocks we want to invest in should have dependable enough business models to generate reliable earnings figures under the SEC’s requirements. We would much prefer to see a company with erratic GAAP earnings and know to quickly move on rather than be enticed by the potential mirage of non-GAAP accounting adjustments. There are just too many fish in the sea.

 

Besides GAAP and non-GAAP earnings, some investors (us included) like to analyze a company’s free cash flow payout ratio. Unlike earnings, which are impacted by non-cash accounting charges, free cash flow measures actual cash generated by a business each period.

 

For this reason, free cash flow can give a more realistic look at a company’s dividend payout ratio. After all, free cash flow is the lifeblood of a company. Without it, the business cannot sustainably pay a dividend. Both earnings and free cash flow payout ratios can be seen using our Stock Analyzer tool.

 

The final major difference in how the dividend payout ratio can be calculated is the time period over which it is measured. Some investors will use forward earnings estimates for a company, which are based on analysts’ projections of how much profit a firm will generate over the next year.

 

Others calculate the payout ratio based on the company’s results that have already been reported over the last 12 months or its most recent fiscal year.

 

We use the company’s actual results reported over the last 12 months to calculate our payout ratios and prefer to ignore analysts’ estimates of the future. Our decision reflects one of our favorite proverbs:

“A bird in hand is worth two in the bush.”

Essentially, analysts’ projections of earnings often miss reality by a material amount and frequently turn out to have been overly optimistic. This can result in projected payout ratios that mislead the investor, although it can also alert investors of an expected increase or decrease in a company’s profits as well.

 

We would rather deal with reality and take an honest assessment of a company’s recent financial results. However, there are admittedly pros and cons to both approaches.

 

Analyzing Dividend Payout Ratios

What is a good dividend payout ratio? Like the answer to most investing questions, it depends. As seen below, the S&P 500’s 10-year median dividend payout ratio is about 30%, but there is a lot of variance by stock sector.

 

Dividend Payout Ratio

Source: FactSet

 

Stable, mature sectors such as telecom, utilities, and consumer staples maintain the highest payout ratios. This doesn’t mean these companies have riskier dividends. In fact, these are some of the best stock sectors for dividends because of their stable cash flows.

 

On the other side of the spectrum, the technology sector has one of the lowest payout ratios. Technology businesses are generally characterized by a faster pace of change and must continuously reinvest for growth to remain relevant and increase profits. As a result, they are often better off paying out less of their earnings as a dividend.

 

In other words, a company with a “high” payout ratio of 75% isn’t necessarily good or bad. It really depends on the stability of its business model and a number of other factors. However, generally speaking, we prefer to invest in dividend stocks with a payout ratio below 60%. Lower payout ratios provide more cushion for the dividend and make it easier for dividend growth to continue, even if earnings hit a temporary rough patch.

 

Besides remaining aware of differences in payout ratio levels by sector, which are largely driven by business model stability and reinvestment needs, investors should remain aware that dividend payout ratios change over time. As you can see below, the S&P 500’s payout ratio has oscillated between 25% and 50% over the last 15 years, increasing during recessions and retreating during times of economic expansion.

 

Dividend Payout Ratio

Source: FactSet

 

Analyzing the level, trend, and historical volatility of a company’s payout ratio can reveal a lot about a business and the safety of its dividend. The chart below shows Coca-Cola’s (KO) free cash flow payout ratio over the last 11 years. Unlike the trends we saw in the S&P 500’s payout ratio above, Coca-Cola’s payout ratio has been extremely steady.

 

 

Dividend Payout Ratio

Source: Simply Safe Dividends

 

While Coca-Cola’s dividend payout ratio was relatively high at 71% in 2015, this doesn’t concern us much given the historical stability of its payout ratio. This is usually an indicator that the company has earned consistent free cash flow each year and is less sensitive to the economy.

 

It’s also nice to note that Coca-Cola’s payout ratio hasn’t increased by that much over the last 10 years. This means that the company’s dividend growth was mostly fueled by growth in its free cash flow and could be more sustainable going forward (a company’s payout ratio stays flat if the dividend grows in line with its profits; the payout ratio rises if the dividend grows faster than profits).

 

Investors can view 10-year dividend payout ratios for any company using our Stock Analyzer, which is where the chart above came from.

 

Look Beyond the Dividend Payout Ratio to Better Assess Dividend Safety & Growth

As we outlined earlier in our article titled, “5 Tips to Find Safer Stocks,” payout ratios are only one factor that investors should analyze before deciding to buy or sell a dividend stock.

 

The dividend payout ratio represents a snapshot in time. Unfortunately, business conditions can change quickly, and each business model handles change differently.

 

Some companies enjoy few fixed expenses and sell recession-resistant products, lessening their exposure to the economy. On the other hand, many businesses are tied closely to economic growth and are severely impacted by expansions and contractions.

 

Depending on the current macro environment and type of business model being evaluated, the dividend payout ratio can be a misleading indicator of dividend safety and growth potential.

 

Let’s take an example. Observe the free cash flow payout ratio below of Dow Chemicals (DOW) and suppose you were looking at the stock in 2008. You would have seen a company with a payout ratio consistently below 60% and more than 20 consecutive years of uninterrupted dividends, providing a sense of comfort.

 

Dividend Payout Ratio

Source: Simply Safe Dividends

 

Then, the financial crisis hit. Many of Dow’s businesses are extremely sensitive to the economy’s health and have a high proportion of fixed costs. As a result, we can see Dow’s free cash flow payout ratio nearly tripled from 2008 to 2009, and the company was forced to cut its dividend. All of that happened in less than one year!

 

Dividend Payout Ratio

Source: Simply Safe Dividends

 

Dow is a great example of why investors should look at a company’s dividend payout ratio over time to gauge its historical volatility and long-term trend. Companies with safer dividends will typically be characterized by a smoother payout ratio with no major spikes.

 

Dow also highlights the importance of understanding some of the other major risk factors impacting a company’s ability to pay its dividend. Some of the big ones we pay attention to are the consistency of a company’s free cash flow generation (cash is needed to pay the dividend), the cyclicality of the business model, how much debt is on the balance sheet, the company’s performance during the last recession, near-term business trends, and more.

 

It takes time to collect and analyze these factors, which is why we created our own Dividend Safety and Dividend Growth scores to save investors time and help them make better investment decisions. A company’s dividend scores can be retrieved any time using our Stock Analyzer and can serve as a nice gut check before deciding to buy or sell a stock. For those that are curious, more information about our dividend safety and growth scores can be found here.

 

Concluding Remarks

The dividend payout ratio can be a helpful indicator to begin sizing up the safety and growth prospects of a company’s dividend payment. We generally prefer to invest in companies with payout ratios below 60% for dividend safety and growth purposes, but we are willing to go higher if the business is extremely stable (e.g. an electric utility company).

 

Importantly, the dividend payout ratio is just one piece of the puzzle when it comes to assessing a company’s quality. In our opinion, factors such as business model volatility and financial leverage are perhaps more valuable measures of dividend risk, but they should all be analyzed together and over long enough periods of time for the best possible assessment of risk.

 

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