In this month’s issue of Money Magazine, I came across an article entitled “When the Wilder Ride is Worth It”. The article was addressing how sometimes a company’s stock and dividend payment can be a better prospect for stable income than its bond. To make this comparison, they looked at the return of the bond against the dividend appeal (which was largely based on it’s payout ratio) and any inherit stock risk based on the company itself.
Whenever I find an article like this about semi-guaranteed income, I tend to pay extra special attention to it – and with good reason. Strategies such as taking advantage of dividend payouts will be important to my financial situation because it will be one of the key elements that helps me to achieve a successful early retirement.
“How?” you might ask? Remember that your traditional retirement accounts like your 401k and IRA are non-accessible until age 59-1/2. So if you retire before then, you’ll need something to bridge the gap between now and when you can have full access your funds. This is where a strong taxable portfolio may have some benefits. But it can’t be a collection of just any investments. Since this is part of your retirement strategy, you’ll need to pick investments that have a high likelihood of success and can deliver solid income without you having to dip into the principal. One of those key elements, I believe, will be a portfolio of strong high paying dividend stocks.
So getting back to the Money magazine article, how do we determine what makes a good prospect for a stable dividend stock? One of the key metrics they focused on was something called the dividend payout ratio.
What is the Dividend Payout Ratio?
Although there are many evaluation metrics you can use to judge a stock and its dividend payment, the dividend payout ratio is one of the most basic ones to use. The equation is:
To put this into words, it is a percentage of how much the company is paying out to its shareholders relative to the earnings it is taking in.
Alternatively, we could also write the dividend payout equation as:
This statistic along with many others is usually readily available from pretty much any financial media site (such as Yahoo Finance) that you choose to research stocks.
The Value of This Ratio:
There is one point from the Money Magazine article that I will have to contradict and explain further.
In the article, they made the generalization that the payout ratio is an important metric to examine because it can provide a sign as to whether or not there is any potential room for future dividend growth. Here are the thresholds they pointed out:
- 40% or less is typically a sign that dividends can climb at the same pace as the company’s earnings.
- 70% or above demonstrates that there’s decidedly less room for growth.
While there may be a small bit of truth to that statement, it is important to really understand what you are reading when you look at this metric. Here are two vital things to keep in mind:
1) Earnings are Forward Looking:
For example, consider the stock for Verizon Communications (VZ). It has a whopping dividend payout ratio of 508% !!! Does that mean that the company is paying out 5 times its earnings to its shareholders?
Absolutely not. What’s happening is this:
- That 508% is based on the dividend payment shareholders are receiving now ($2.06) and the earnings per share (EPS) from last year ($0.40).
- But Verizon has decided to pay this much out in dividends because they believe their EPS for this year will be $2.80. So in reality the company will only be paying out about 74% of the earnings to its shareholders in the future.
Therefore, the takeaway is that sometimes a high dividend payout ratio is not necessarily a bad thing if you put it in context with what else is going on with the company.
2) Use Caution Comparing Two Different Industries:
If you were just to blindly follow the Money magazine advice, it may be tempting to try to compare all stocks based on this metric. But that would also be the wrong way to interpret this metric.
For example, McDonalds (MCD) currently has an attractive dividend payout ratio of 54%. Pitney Bowes (PBI), although it may appear to be an insane investment with a dividend yield of 10.3% (the dividend payment is $1.50 when the stock price is only $14.60), has a dividend payout ratio of 68%.
Comparing both of those to Verizon (VZ) and its surface reading of 508%, which one do you feel is the better investment?
The answer: You need more information.
Blindly comparing VZ to MCD or even PBI is not really the best way to interpret all this data because you are making comparisons across three different industries.
If you really wanted to understand VZ better, you would be smart to compare it to AT&T (T). Notice that T also has a seemingly very high dividend payout ratio of 141%. But as you know from the Verizon example, you need to look deeper to really understand what is happening with the stock. A closer looks on Yahoo Finance shows that AT&T’s current EPS of $1.30 is expected to almost double to $2.52. With a $1.80 dividend payment, that means the stock will soon have a payout ratio of about 82%. Do you see how this follows more closely with what is happening with Verizon?
Never Look at Just One Ratio:
As much as I love collecting valuable stock metrics and tricks for analyzing what is happening with a company, I can never forget how important it is to do more than scratch the surface when it comes to understanding what direction the company is going. You must always remember to base your decisions on several key pieces of information and use them together to really get the whole picture. To take a metric or ratio at face value can not only be misleading, but it could potentially cause you to miss out on a terrific opportunity.
To my fellow stock investors, do you pay attention to the dividend payout ratio or other specific metrics? Who else sees building a solid income portfolio as an important part of their investment strategy?
Disclaimer: I own shares of MCD, T, VZ, and PBI.
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3) Getting the Highest Dividend Stocks Using the Dogs of the Dow
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Glen @ Monster Piggy Bank says
I look at the payout ratio as well as the long term payout for the company, I want to make sure that this isn’t just a one off payment and that the company consistently pays a good dividend.
I also don’t want to get stuck with a one time high payout. This is why I tend to stick with well known large-cap stocks; especially the ones that have a reputation of increasing their payouts.
My Financial Independence Journey says
I’m a dividend investor so I pay a lot of attention to payout ratio. But it’s a little more complex in that you have to consider the payout ratio of the industry as a whole. Some industries, like tobacco, telecoms, and utilities, just have higher payout ratios.
Some investment classes like REITs will have payout ratios near 100%, but that’s because they’re required to pay out at least 90% of their income.
I completely agree with you on the complexity of the dividend payout ratio. Each company has a different position and conditions and its ratio of 200% still can be justified. There is a lot of companies out there who have the ratio over 100% and conventional wisdom would say it is not sustainable and yet these companies pay dividends for many years and increase it for many years. One example which comes on my mind now is AT&T which historically had a ratio at 100 – 123% and yet it increased dividends for 8 consecutive years.
Good points. You have to consider this (and other stock market factors) in the context of the industry if you really want to get an apples to apples comparison.
William @ Bite the Bullet says
Very important! A while ago, I saw the high yields of the mREITs (NLY, etc.) but when I saw there was no coverage, I passed. I’m glad I did. 🙂
Will, Annaly is a totally different story. REITS are required by law to pay 90% or more in payouts (I wouldn’t call it a dividend) and with it’s current 114% payout this company is actually in the lower range of all other REITs out there, so not that bad.
It is actually a great example of how complex the payout ratio is and that you cannot compare companies to a flat ratio of let’s say 70% and below. REITs will be always larger than 70%.
It’s interesting what this metric can reveal. I’m not sure how any stock can afford to payout beyond 100% for very long.
William @ Bite the Bullet says
Martin is right… I didn’t consider that. Turns out they borrow and issue more stock to sustain growth in the payout.
But coverage is still a key factor to look at. One of the dividend aristocrats (I forget which one) has kept growing their dividends to say on the list, even though profit growth has not kept pace.
For me to invest in a dividend stock, I need at least 2x coverage…
You cannot look at the dividend ratio the way you are doing and you cannot compare two different companies in a totally different industries. First, the payout ratio is reflecting the future outlook of the company and not what happened in the past. If AT&T pays $1.8 annual dividend, it pays it NOW and it will pay it in the FUTURE or at least until the next quarter when the company may announce either an increase, keep the dividend same or lower it. So the dividend is paid from today’s earnings and future earnings. But the ratio is comparing it to the earnings which happened in the past. So comparing the dividend ratio to last fiscal year (2012) provides you with a payout ratio of 140% but that is compared to EPS of 1.25. The outlook for 2013 EPS however is 2.52 and with the same dividend per share ratio the payout for 2013 is suddenly 71%, for 2014 the payout will be 66% and in 2016 it will be 58% if the dividend ratio remains the same as today. Given this, AT&T is confident in sustaining the dividend at least at current levels. There are of course other factors to determine the dividend sustainability of the dividend, but that is beyond this post. Given this outlook I believe AT&T actually has a good potential for dividend growth although it displays high payout ratio. You just have to look at what’s behind it and what future lays in front of it.
Thanks for the clarification on the nuts and bolts of what goes into this ratio. I never mind when someone wants to dig a little deeper into the technical aspects of what these metrics represent.
JC @ Passive-Income-Pursuit says
The payout ratio is a good quick measure, but I prefer the FCF payout ratio to the standard EPS ratio. Cash flow isn’t as easily manipulated by one-time items, such as AT&T’s botched T-mobile acquisition. Whereas the earnings were. If you’re going to look at the payout ratio it’s important to look back a few years also to see what the norm is for the company to find out if there’s a reason for a big change in the payout ratio.
Without reading the Money article, I’d have to disagree about the dividend from some companies being a better source of stable income than a bond from the company. There’s nothing that says a company has to pay a dividend, whereas the coupon for the bond must be paid out. A dividend can be cut at anytime. Now some companies dividends are pseudo-bonds (KO, PG, JNJ…) because the company is very stable so that could be the point of the article.
You’ll be delighted to know that the Money article supports your opinions. They were going through a handful of stocks and showing whether the dividend or stock would be a more stable choice for sustainable income. In many situations, the bond proved to be the better choice.
I pay very close attention to the payout ratio for signs of an impending dividend cut. Above 75% for an industrial company would certainly send me running.
I’m as focussed on signs that a company can grow its dividends, so I also look for growth in revenue and operating cash flow. I like to see these rising over time as well.
Good catch. I suppose if all revenue and operating cash flow are increasing while the divided ratio is somewhat low, then that would be a good indicator of growth potential.
[email protected] says
I have not done much investing in individual stocks, but looking at potential divided payment would be a big consideration. I do wonder with all the rage being in dividend stocks, is it likely that dividends will be cut when the stock market corrects, as it eventually will. I think a good mix is still the best bet any day. I always look forward to my Money magazine, the only thing I subscribe to. Certainly some good discussion articles in there.
Truth be told: When I’m running low on blog ideas, I can always find a great article in MONEY to discuss and explore.
Financial Independence says
Such a great article. Than you for that.
The only other thing I would add – it depends on the industry. Some of them are more capital intensive, than others. For example, ratio between McDOnalds and ExxonMobil would be different.
Exxon is heavily investing in equipment which cost a lot of money. So you need to pay at both dividend payout ration and % (yield), i.e. what are you getting vs. stock price.
I recently run through the all energy stock companies, see how do they do…
Primarily focusing on the yield and reserves replacement ratio.
Thanks FI. Yes, I should have mentioned that these ratios are better kept in perspective relative to their industry. Good mention of the reserves replacement ratio. I will need to look closer at this one.
Stock Analysis says
Great post! We will be linking to this great
post on our site. Keep up the great writing.
Thanks! Hopefully the 12 month update ends on a positive note.