Understanding the dividend payout ratio and biggest dividend risks will help put cash in your pocket.
There are three major risks to a stock’s dividend payout ratio that WILL mean the difference between solid returns or big losses.
Ignore these risks or just hope they don't hit your portfolio and you could lose thousands of dollars. Understand the risks and learn how to avoid them and you'll watch your portfolio spin off cash in dividends every month.
In this video, I’ll not only explain the dividend payout ratio, I’ll reveal those three payout ratio traps and how you can be a better investor.
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What Investors Don't Know about the Payout Ratio
We’re in the middle of a series of videos on dividends and anyone in the community knows I’m a huge fan of these cash flow stocks. Research upon research has shown that dividend stocks tend to do better than other investments.
Probably the most famous, we see here research by the Ned Davis firm that over nearly four decades, dividend stocks returned an annual rate of 7.2 to 9.5% compared to a return of just 1.6% on stocks that didn’t pay a dividend.
But one of the most important concepts in dividend investing isn’t well known by most investors. This metric goes to the very heart of a company’s dividend payment and its ability to keep paying or even grow that dividend. Ignore this measure and the risks we’ll talk about and just wait for that stock to collapse because it will happen if you don’t know what to watch for.
We’re talking about the dividend payout ratio and this is simple the percentage of the company’s profits it pays out as a dividend. I’ll show you two ways to calculate the payout ratio in a moment but basically it’s just the dividend divided by a company’s earnings, it’s net income.
What is the Dividend Payout Ratio?
Now if we look at the two sides to the payout ratio, you’ll see just how important it is and maybe even start to see some of the risks we’ll talk about. Dividends paid by a company are a big responsibility, it’s a commitment not only to make a current payment but most investors see it as a commitment to make future payments as well.
All you need to do is look at any company that’s cut its dividend payment and watch the stock price to know how important that forward planning for cash flow is for a company.
On the other side of the dividend payout calculation is just as important, the company’s earnings. Stocks are an ownership on those earnings so this is directly related to a stock’s value and it’s price.
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How to Calculate the Dividend Payout Ratio
The payout ratio is super easy to calculate and a couple different ways you can do it. Some websites or even the company’s financial statements may tell you the dividend payout ratio but it’s so easy to calculate on your own, I like to double-check the numbers anyway.
The first way to find the payout ratio is just to go to a company’s financial statements, so here we are on the Apple stock page on Yahoo Finance and we’ll click on Financials in the menu. This will take us to the three financial statements.
The income statement shows the sales and profits of the company over either a year or three months. The balance sheet shows us the company’s assets and debts at a point in time and the cash flow statement shows us the actual cash in and out of the company over a year or three months.
These three statements are something we’ve talked about on the channel and you know I’m a big believer in using this Statement of Cash Flows rather than the income statement. Most investors get caught up in those sales and earnings on the income statement but these are all manipulated by management to make the company look as profitable as possible. It’s much harder to bias those cash flow numbers because it’s actual cash accounting and in fact, this is where professional analysts spend most of their time, looking at those cash flows.
Anyway, so we’ll first click over to the cash flow statement and make sure it’s set on annual here. Then we’ll come down here to Dividends Paid, so this is the annual amount Apple paid out as dividends in this year and this number we see is in billions of dollars. So the company paid out $11,561,000,000 in dividends this last fiscal year.
Now we’ll scroll back up and click over to the income statement which will show us the net earnings for that year. Here we’ll look for this Net Income from Continuing Operations or Net Income Available to Shareholders and we see it was $53,394,000,000 for the year.
So we’ll open our calculator and if we take our eleven billion in dividends paid and divide by the fifty-three billion and change in net income for the same period, we get a dividend payout ratio of about 22% for Apple during that year. Now this payout ratio is going to fluctuate a few percent from year to year so you should really take an average over a few years but either way gives you a good idea for comparison.
Another way to find the dividend payout ratio, and it really makes no difference which way you use, is to do it on a per share basis. So here we’re on the Apple stock page again and we see that Apple pays $2.92 a year per share in dividends.
Understand this is a forward dividend so the current quarterly dividend times four. Now we need the per share net income or earnings so we scroll down to this Earnings graphic and we see each of the last four quarters. We can use this method anywhere you find per share dividends and earnings so not just Yahoo but the site makes it really easy.
First we’ll add up each of these quarters’ earnings to get the full year number and we get earnings per share of $12.16 over the last year for Apple. Then we just take that $2.92 in dividends and divide by the earnings for a dividend payout ratio of 24%.
Understand this is going to be slightly different than the other method because you’re using the current dividend times four so dividends over the next four quarters and using the last four quarters in earnings. Technically, you should find the last four quarters in dividends but this will give us an estimate that’s as close as we need for comparisons.
Dividend Investing Risks
Now that we have the payout ratio for a stock, I want to reveal three risks to looking at this you can’t ignore. These three ideas are going to be critical to using the dividend payout ratio and picking the best stocks.
The first risk you want to watch for in the payout ratio is a company paying out too much of its earnings as a dividend. I know we all love dividends and it’s great seeing that high yield but there’s a tradeoff you need to watch. A company paying out most of its profits as a dividend isn’t going to have much left to grow the business, to grow those earnings.
Now we know that the share price of a company is based on those future earnings, that’s what you’re investing in is a share of those profits. If earnings aren’t going to be increasing or worse yet might decrease because the company hasn’t spent enough to stay competitive, then that stock price could suffer. Obviously, it does no good to collect a juicy 10% dividend yield on a stock if the share price falls by 15% during the year or over a period.
Of course the question becomes, how much of earnings can a company pay out before it starts limiting growth? For this you can start by just comparing it to the dividend payout ratio for other companies in its industry.
Remember, and this is extremely important in a lot of investing ideas, you always want to compare a company with others in its industry, not just with all other stocks or other companies outside the industry.
Here we see a few industries and their payout ratio. This is data collected by Professor Damadaron of the Stern School at NYU, a great resource for investors and you can see how much some of the industries differ on their payout ratio. You’ve got household products and utility companies that pay out the majority of their earnings some even more than their earnings as dividends. Then you’ve got the biotech drug industry that almost pays no dividends at all.
Think about this from a management perspective. The growth prospects are more limited in older industries like household products or in regulated ones like utilities. Debt is very easy to come by for these industries with stable cash flows so they can pay out lots of dividends and borrow if they need more money.
On the other hand, industries like biotech and semiconductors, it’s all about reinvesting in research and development to create new products. Debt is more expensive because sales and profits are more volatile so these companies need to keep more of their cash back instead of paying it out as dividends.
This is why you absolutely must compare companies with others in their industry. This goes for not only comparing the dividend payout ratio but other metrics like price-to-earnings, dividend yield, and sales growth as well.
Comparing a payout ratio with the industry average, you start to do some analysis. If they’re paying out more, is it going to be at the expense of growth. If they’re paying out less, does that mean the company will grow faster or is it an opportunity to increase the dividend? You can also compare a company’s payout ratio with it’s own history, so going back to look at how the payout ratio has changed and how that has affected sales growth.
The second place you need to look when you’re looking at dividend stocks and payout ratios is whether the payment is supported by cash flows.
Dividend payments and a share buyback program can be a big drain on cash and can turn into a problem if that cash flow evaporates. In fact, this is what happened to Warren Buffett in his IBM investment, one of the worst investments he’s ever made. Buffett started buying shares in IBM in 2011 seeing a cheaper share price and chasing that high dividend yield. The company also had a huge share buyback program that was boosting its earnings per share.
The problem was, and for this we look at the Statement of Cash Flows again, it was paying for all this with lots of debt. If you go down to where it says Common Stock repurchased and Dividends paid on the cash flow statement, we see that IBM was burning through about $18 billion in cash through the dividend and buyback each year.
Now you look a little further down to where it says Free Cash Flow. This is the cash generated by the business that Operating Cash Flow and minus capital expenditures which is cash invested in equipment and other things to keep the company running. So this Free Cash Flow is a measure of how much cash is left over after reinvesting enough to keep the company stable and you see that it was well under that $18 billion for all five of these years.
So IBM was spending all this cash buying back its own shares and paying out a dividend and it was paying for it by just piling on the debt. If you look at the difference between the debt issued and the debt repayment, the company borrowed more than $24 billion over those five years to pay for all this.
This is something that obviously couldn’t go on forever. The company’s sales weren’t rising fast enough, interest payments were ballooning and the stock price tumbled from a high of about $215 a share in early 2013 to $150 per share towards the end of 2017 when Buffett finally gave up on the investment.
This is something you have to watch, especially in those dividend stocks with a high payout ratio. You need to check back each year into that Statement of Cash Flows, look at how much cash the company is paying out in dividends and share buybacks. Then look at where that money is coming from. Is it coming from cash generated by the business, that Cash Flow from Continuing Operations, or is it coming from new debt? Is the company still spending as much as it has in the past on capital expenditures, that money reinvested to keep the company competitive and grow it, or is it cutting back in order to meet those cash payouts?
Dividend Investing in REITs and MLPs
Our third risk to remember when you’re looking at the dividend payout ratio is you can’t apply this to real estate investment trusts, REITs, or to master limited partnerships, MLPs.
We talked about this in a prior video on these two special types of companies. REITs hold and manage real estate and then pay out the majority of cash flow to investors. MLPs hold energy assets like pipelines and storage facilities. Both get a special tax break by paying out most of the annual income as dividends so these are some of the best dividend yielding stocks you can find with a yield three-times the market average.
The problem is that these two types of companies have so much in depreciation expense, that’s the accounting trick they get to use on the income statement. They have these properties or pipelines and get to take a certain amount off the value each year to deduct it from their earnings.
That makes their earnings, that net income look artificially low because the deduction isn’t actually cash going out the door. So if you take the dividend payment divided by this artificially lower net income for these types of companies, you get a payout ratio of over 100%, making it look like they’re paying out more than they have and in danger.
With MLPs and REITs, you have special earnings measures you use instead of that net income. For REITs, you use what’s called the funds from operations or FFO. For MLPs, you use what’s called the distributable cash flow or DCF. I’ll show you how to find both of these next but they’re always available on a company’s annual report as well so you don’t necessarily have to calculate them.
Just like with using net income when we calculate the dividend payout ratio, you use these two measures, the FFO for REITs and the DCF for MLPs, to find how much of the company’s core earnings it’s paying out as dividends. You can then compare that to similar companies and to the company’s own history to analyze if it’s maybe paying too much or could increase the payout.
While sustainable DCF is a better measure, most people use the DCF as reported because it’s sometimes the only number reported. To get to DCF, you also add back that income from non-controlling interests as well as working capital reported. The big one here is adding back this proceeds from asset sales. This is technically proceeds the company can return to investors, a company can’t forever be selling its assets and still keep business running so that’s why we use that sustainable DCF if it’s available.
For real estate trusts, FFO is very similar to that DCF we saw with MLPs. You take the reported net income of the REIT and add back depreciation but minus out any gains they made on property sales. Those property sales are a source of income but not something the REIT can do forever and expect to stay in business.
Investors also look at the adjusted funds from operations this AFFO, which takes out capital expenditures. Capex here is money the company spends to keep its properties in good shape so maintenance spending. Remember, the idea is to find how much cash the company has available to distribute without cutting into money it needs to run the business.
We’re about half way through out 2019 Dividend Stock Challenge portfolio and the stocks are blowing up. The portfolio is up over 24% so far and beating the market by nearly ten percent. Check out the portfolio and don't forget to always be watching for those dividend payout ratio risks and warning signs in your stocks.