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.
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.