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Why You Should Care about Dividend Payout Ratio?

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By Paul Dykewicz

A company’s dividend payout ratio indicates how much money is returned to shareholders rather than kept by a company to reinvest in growth, pay off debt or boost cash reserves.

The payout ratio, first and foremost, helps to assess whether a company’s earnings can sustain the payment of a dividend. An investor wants to know that a dividend can be paid comfortably or even raised as part of his or her decision-making process.

A plus for investors is that companies are extremely reluctant to cut dividends, since such a move can drive the stock price down and reflect poorly on the management. Shareholders will want to see a dividend payout ratio under 100% because anything above that level indicates a company is giving more money back to its investors than it is earning.

If a company’s payout ratio tops 100%, it sooner or later may be forced to cut or suspend the payments. A payout ratio above 100% behooves an investor to consider whether a company is simply enduring a particularly challenging period, a seasonal lull that may occur each year or if it is starting a long-term decline.

Motivated investors can look up projected future earnings of the company online from analysts who track the stock. Try to find analysts who may calculate future dividend payout ratios, based on the company’s projected financial performance.

To avoid sending a negative signal to investors, the management teams and directors of public companies typically are extremely reticent to reduce or stop their dividends. If they do opt to cut a dividend or announce that such a possibility is under consideration due to cash flow concerns, watch out.

But do not panic if a dividend payout ratio tops 100%, since you will want to find out if a given company’s business is cyclical and endures ebbs and flows in its earnings and revenues. Compare results for the same quarter during the prior year to help you factor in such trends.

Keep in mind that a company still may be able to weather a bad year or two years without suspending its dividend payouts, and it is often in the organization’s best interest to do so to maintain the confidence of its shareholders.

But also pay attention if a dividend appears to have plateaued, especially if the company previously had increased them each year. The failure to continue to hike dividends annually could be a warning sign, even if the dividend payout ratio remains below 100%.

When assessing a company’s dividend payout ratio, consider its level of maturity. For instance, a start-up company should not be expected to pay a dividend since it likely would need to put its full financial resources behind the development of new products and related efforts to market and sell them. Companies that are further along in offering profitable products and producing strong earnings are the best candidates to pay dividends and have strong dividend payout ratios.

One such company is Apple (Nasdaq:APPL) , which started to pay a dividend in 2012 after more than two decades of operation. At the end of 2015, Apple had amassed $101.5 million in retained earnings, even though it had begun paying dividends to its shareholders.

Luca Maestri, Apple’s CFO, announced that the company generated operating cash flow of $27.5 billion during the fourth quarter of 2015 and returned more than $9 billion to investors through share repurchases and dividends.

“We have now completed $153 billion of our $200 billion capital return program,” Maestri said.

Other ways that a company can return value to its shareholders aside from paying dividends to its common stock shareholders include buying back shares and paying dividends to preferred stock holders.

One kind of organization that is required to pay a dividend is a real estate investment trust (REIT). By federal law, a REIT must pay out at least 90% of its earnings to shareholders. Master limited partnerships (MLPs) also usually have high dividend payouts, too.

However, the performance of real estate investments can be cyclical, as well as MLPs involved in the energy business. Such businesses can offer significant capital appreciation when they are on the rise but lose value when real estate and energy businesses fall out of favor with investors.

A dividend payout ratio can be a useful tool in identifying public companies that are able to afford to pay, sustain and even raise their payments to shareholders. For people seeking regular income payments, the ratio is worth knowing for any company whose shares you want to buy or keep.

Paul Dykewicz is the editorial director of Eagle Financial Publications, editor of Eagle Daily Investor, a columnist for Townhall and Townhall Finance, a commentator and the author of a new inspirational book, “Holy Smokes! Golden Guidance from Notre Dame’s Championship Chaplain.” Paul has written for a number of prominent organizations, including the Wall Street Journal, Dow Jones and USA Today. Follow Paul on Twitter @PaulDykewicz.

 

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