When it comes to dividend stocks, investors focus solely on yield at their own peril. A higher dividend yield, while nice in a bubble, doesn’t always translate into a better investment.
No, investors need to be looking at several more things than that one percentage sign — and one of those things is “payout ratio.”
A stock’s payout ratio is the percentage of a company’s earnings paid out to investors as cash dividends. And while you want a high yield, when it comes to payout ratio, lower is typically better.
A high ratio means that a company is paying most of its earnings out in dividends, which means it has less financial flexibility to do more with its dividend. Some companies actually sport ratios of more than 100%, which means they pay out more in dividends than they are making in profits. Companies with extremely high payout ratios, then, are less likely to increase their dividend meaningfully in the future, and usually are at greater risk of a dividend cut.
However, a smaller payout ratio (typically, under 50% is considered low) means a company isn’t stretching itself to pay its current dividend, and in fact probably has more room to pay an even bigger dividend in the future.
If you invest in dividend stocks, companies with low payout ratios should be on your radar. We’ll help you out by showing you seven dividend stocks with plenty of payout wiggle room:
Dividend Stocks With Low Payout Ratios: Oracle Corporation (ORCL)
Dividend Yield: 1.5%
Payout Ratio: 21% (Based off estimated forward earnings)
In terms of dividend stocks, enterprise software firm Oracle (ORCL) doesn’t exactly look like a great one on the surface. After all, its yield isn’t even keeping pace with the 10-year T-note.
Still, Oracle could be an amazing deal for investors looking for dividend growth.
Already a software kingpin, ORCL has worked hard to expand its cloud offerings and move customers toward usage-based platform-as-a-service (PaaS) contracts and new subscription agreements. This will create a constant flow of cash into Oracle’s coffers — as will its continued leadership position in database management software.
As Oracle transitions fully to the cloud and realizes potentially higher margins from subscriptions, the firm’s earnings and cash should only benefit.
That’s great news considering ORCL’s lousy payout ratio of just more than 20% on forward earnings. That means Oracle could literally double its payout without dedicating even half of its earnings to a dividend (and it would yield a nice 3% to boot).
Add in expected earnings growth as well as a huge war chest of more than $50 billion, and you have a cash-rich tech stock with plenty of income potential.
Dividend Stocks With Low Payout Ratios: Aflac Incorporated (AFL)
Dividend Yield: 2.5%
Payout Ratio: 24%
Everyone knows the duck, but not everyone knows how good of a business or dividend stock Aflac (AFL) really is.
The firm’s main product is supplemental insurance — its famous “Get hurt and get paid” policies — and that has been a pretty good business for AFL over the past few decades. Aflac continues to bring in higher premiums, and insurance companies are required to hold onto these premiums. It’s called “float,” but just think about it as an interest-free loan.
Aflac is able to invest this float, and it has done pretty well with it over the past few years. Meanwhile, insurance claims against this float have been pretty low thanks to the supplemental nature of these polices.
Basically, AFL gets free money, invests it for a profit, then only has to pay back some of the original money.
Some of that trickles down into your pockets, and it’s a little bit more each year. Aflac has managed to increase its dividend every year since going public back in 1983, and it can do a lot more with less than a quarter of its profits funneling into the dividend.
Dividend Stocks With Low Payout Ratios: Phillips 66 (PSX)
Dividend Yield: 2.6%
Payout Ratio: 30%
There are numerous reasons to love refiner Phillips 66 (PSX).
For starters, PSX has made hay while oil and natural gas prices have plunged. The company has feasted on cheap crude oil price because crack spreads — or the difference between that input price and the price for refined products such as gasoline, jet fuel and heating oil — have remained high. The same can be said of the firm’s various petrochemical joint ventures.
And even though crack spreads have slipped recently, Phillips 66 continues to rake in the cash thanks to the addition of midstream assets to its terminal. That includes pipelines, shipping, terminaling and natural gas faction capacity. All of these assets have different return quotients and function differently than straight-up gasoline refining.
What investors get is a total package that has turned PSX into an earnings machine. However, only 30% of those earnings reach investors’ pockets via dividends. More could be on the way as the high-margin midstream assets and chemical refine operations lead.
Dividend Stocks With Low Payout Ratios: Texas Instruments Incorporated (TXN)
Dividend Yield: 2.6%
Payout Ratio: 48%
Investors often overlook the technology sector when searching for dividend stocks. Big mistake. Many tech stalwarts — such as semiconductor superstar Texas Instruments (TXN) — actually gush cash.
Texas Instruments is smack-dab in the middle of semiconductor heaven. TXN makes analog chips — the kind found in remote controls and calculators — and demand for those is pretty steady and predictable. But TI also makes chips for today’s hottest and most high-tech technology concepts, such as near-field communication chips, heads-up displays, bio-sensing devices and web/grid connectivity. That’s the stuff that will power Texas Instruments forward.
All in all, the combination of the two sides has produced some hefty, growing earnings — and TI currently pays out less than half of them in the form of dividends. Growth in earnings should result in dividend growth; already, TI boasts a 12-year streak of boosted payouts.
Dividend Stocks With Low Payout Ratios: Illinois Tool Works Inc. (ITW)
Dividend Yield: 2.1%
Payout Ratio: 37%
To say that Illinois Tool Works (ITW) makes a lot of stuff would be an understatement.
ITW makes everything from those plastic six-pack rings and commercial ovens to decorative countertops and gasoline caps for cars. The fact that it serves a diverse range of industries — from automobiles to food producers — has helped Illinois Tool Works weather a lot of storms, and has made it one of the best dividend stocks around.
Illinois Tool Works keeps growing earnings amid various global headwinds, and that has translated into a long, long streak of dividend hikes. ITW has improved its dividend every year for the last 53 years, putting it in the exclusive group of Dividend Aristocrats.
That low payout ratio gives ITW plenty of ceiling for payout increases, such as the 13.4% bump announced last August.
As the firm continues to execute on its Enterprise Strategy five-year plan, continued margin expansion and cost reductions should help drive earnings even further, which should help drive dividends even higher.
Dividend Stocks With Low Payout Ratios: American Water Works Company Inc (AWK)
Dividend Yield: 1.9%
Payout Ratio: 45%
American Water Works (AWK), which pays out less than half of its earnings as dividends, would make most lists of dividend stocks to buy. AWK is as boring as they come, but boring can be beautiful when looking at dividend stocks.
American Water Works is a water utility that operates in 16 states and having nearly 15 million customers. Water and wastewater service is essential to modern living, and you can’t really go on without it. And while the bulk of AWK’s operations are regulated by local and state authorities, it does have exposure to market-based rates in some areas, which can help pad profits.
Also helping on the earnings front has been American Water Works’ successful strategy of buying up struggling municipal water authorities and systems. AWK has actively targeted smaller systems that need help financially. By purchasing them, towns get an infusion of cash, while the company gets an easy bolt-on transaction. These transactions have turned American Water Works into the largest investor-owned water utility in the U.S., and has helped the firm grow earnings.
AWK has improved its dividend every year since going public in 2008, and its relatively low payout ratio should help keep that streak going.
Dividend Stocks With Low Payout Ratios: Verizon Communications Inc. (VZ)
Dividend Yield: 4.4%
Payout Ratio: 56%
And Verizon might have the upper hand, from a dividend holding perspective.
VZ already features impressive penetration in the U.S. wireless market. In fact, it’s the largest wireless telecommunications provider in the United States. And those 140 million cellphone customers pay a pretty penny to keep their wireless services running. All those fees for data, minutes and other wireless-charges have made Verizon a free cash flow machine. For the past five years, VZ has realized free cash flows north of $10 billion each year.
Bread ‘n’ butter wireless pays the bill, but Verizon can grow, too. VZ has moved hard into advertising via the net and on mobile devices, and its purchase of AOL strengthens that presence. Meanwhile, Verizon continues to snag bandwidth and is currently testing 5G wireless networking, which should give it an upper hand in trends like the Internet of Things, not to mention make it a more attractive carrier option.
While Verizon’s payout ratio is over 50%, its massive cash flows ensure that VZ will be able to pay and improve upon its dividend in the future.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.