As with most things in the investing world, dividends are pretty simple … except when they’re not. While payout ratios are a generally a good gauge of a company’s dividend since it simply can’t pay out money it hasn’t earned, there are always exceptions.
One limitation for a payout ratio is the fact that earnings are used for the calculation, when cash is (usually) what’s actually used to pay dividend. Thus, non-cash charges and asset depreciation might weigh on earnings for some companies — increasing their payout ratio — but not actually affect the company’s ability to pay shareholders.
This has been the case with telecom stocks like AT&T (T) and Verizon (VZ). In fact, the telecommunications sector had an average payout ratio of 156% as of the end of the second quarter, with the sector’s ratio sitting above 100% since the end of 2011.
At first glance, it would appear that telecoms are paying shareholders more money than they earned. But that’s partially because AT&T and Verizon have suffered from pension problems and asset impairment charges — non-cash charges that weigh on earnings, but don’t weigh on the companies’ actual ability to produce cash and return it to investors.
In a case like this — when companies suffer non-cash charges or asset depreciation — you should do a similar exercise, but look at the dividend compared to free cash flow. Free cash flow is the company’s operating cash flow, minus capital expenditures. And again, a ratio north of 60% or is enough cause for concern.
Consider telecom stock Verizon, for example. The company had operating cash flow of $31.5 million in 2012, but spent $20.1 million on capital expenditures. That leaves $11.4 million of cash — more than enough to cover the $5.2 million in dividends it shelled out, as seen by the resulting dividend-to-free cash flow ratio of 45%.
A similar, although more complex, story can be told for real estate investment trusts, or REITs. For one, these companies generally have high yields because they are required by law to pay 90% of their taxable income to shareholders — great news.
But REITs make money — and I’m simplifying here — by buying real estate, then renting it out. The value of that real estate depreciates over time, which can make its earnings and thus payout ratio give a false representation of the payout’s path. Instead, you have to use “funds from operations” in this case — which is net income minus that depreciation.
A similar story is told for limited partnerships, which also are required to pay the bulk of their income to shareholders and should be judged based on cash flow as opposed to earnings.
It’s a tricky topic that requires more explanation, but the key takeaway is simply that payout ratios are useful, but they’re not a one-size-fits-all calculation.
We’ll cover more about these complex investments down the line, but for now, just remember that there’s more to a dividend than a headline yield.
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