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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