It’s always good when a company decides to distribute its profits to shareholders in the form of a dividend, and it’s especially nice when that payout translates to a healthy yield.
But for investors — especially young ones looking for long-term income investments — the sustainability of said dividend is paramount.
Let’s break down the data that can help you decide whether a stock’s dividend can keep chugging along or if a cut is on the horizon. We’ll also shed some light on a few important exceptions.
Understanding a Payout Ratio
The quickest back-of-the-napkin calculation to decide whether a dividend is sustainable is called a “payout ratio” — the relationship between the company’s annual dividend payout per share and the company’s annual earnings per share.
Let’s look at Dependable Dividend stock Coca-Cola (KO). The beverage giant pays a quarterly dividend of 28 cents per share, which means an investor in KO stock will get paid $1.12 per share, per year. Divide that by the $37.89 per share that KO currently costs, and you get a yield of 2.96%. (This basic information also can be found on Google’s and Yahoo’s finance pages, among other places.)
The important part of that equation for sustainability isn’t the yield, though — although the yield is often a good clue; I find that anything north of 6% or so is worth a closer look. A stock might boast an outsized yield because the share price has fallen dramatically, the company paid a special dividend or because it is trying to make up for a lack of organic growth.
Coca-Cola’s yield around 3% hardly screams unsustainable, but calculating the company’s payout ratio can help confirm that.
Coca-Cola is expected to earn $2.10 per share this year. To calculate KO’s payout ratio, you simply divide the company’s annualized dividend of $1.12 per share by its $2.10 per share in annual earnings. That gives you a ratio of 0.53, which means KO pays out 53% of its earnings to shareholders in the form of a dividend.
As a general rule, a low payout ratio means a company’s dividend is more sustainable and might even have more room to grow. While there are always exceptions, a payout ratio north of 60% is at least worth further investigation, considering the average for S&P 500 companies was 32% as of the end of Q2 2013 and is around 50% historically.
A few other things to note:
- Younger companies generally have lower payout ratios because they want to reinvest more of their earnings in order to keep growing. In fact, that’s why many younger companies — like Tesla (TSLA), Facebook (FB) and Amazon (AMZN) — don’t pay a dividend at all.
- Established, stable companies, on the other hand, generally use more of their earnings to reward shareholders and thus sport higher payout ratios. Procter & Gamble (PG), McDonald’s (MCD) and Coca-Cola have payout ratios between 50% and 60%, for example.
- You also have to remember that earnings can fluctuate from year to year. Thus, there’s more security in companies that carry a lot of cash on their balance sheets, as well as companies with low debt — thus, they won’t have to decide between paying interest and paying shareholders.
- History should also be heeded. A company that has a long history of maintaining (or preferably increasing) its payout should get the benefit of the doubt.
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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