The distribution of profits among investors, what a great idea. But some companies get carried away, they don’t think about the future of the company. When it comes to dishing out profits, it’s important to consider the bigger picture.
The dividend payout ratio is the percentage of profits a company pays out in dividend each year to its shareholders. However if the ratio is too high, the company can soon find themselves in financial difficulty, as they don’t have a cash pillow to fall on in times of uncertainty.
The dividend payout ratio can be calculates by taking the dividend per share, and dividing it by the earnings per share of the company in that same year. This will give you an answer in the range of 0 to 1, just times it by 100 to get a percentage.
Here are 5 US companies dividend payout ratios based on the trailing 12 month earnings:
|Company Name||Dividend Payout Ratio|
What is the Best Dividend Payout Ratio?
As you can see the dividend payouts vary from company to company, so there is not a single round figure they stick to. There are many factors that would encourage a company to increase it’s payout ratio, but we’ll get into that later.
Just like there is no single ratio companies stick to, there is no single opinion on what that ratio should be. So I going to provide some examples and what these ratios could mean, then I want you to make your opinion on which you would aim for when investing.
1% – 20%
Companies with extremely low payout ratios could be doing so because of a few reasons:
- Massive fluctuations in profit year to year.
- They are planning for future growth.
- The owners are being a bit greedy.
- The company is on a downward spiral and have ceased innovating.
These reasons are good and bad.
Unpredictable profits are terribly bad for a dividend paying stock. Not only do dividends get cut when profits are lower than expected, but the value of the stock goes down as well. Meaning, not only are you losing dividend income, you are also losing value through depreciation of the stock you hold.
A company which is planning for growth can be seen in two ways… Is their idea good? And, does the management team have a good track record?
Company owners plan for growth all the time, so they are being greedy most of the time, normally a high ranking officer of the company will release a statement explaining the low payout ratio. The reason will usually be planning for growth.
Companies that are on a downward spiral are hard to spot. Think about oil companies, with the increased innovation and massive strides we have taken towards green energy, we have seen these companies either dive into new sectors, or fail to move and fizzle out.
This level of payout ratio is only worth your investment if the company has a strong plan for growth and a capable team doing the work.
21% – 40%
This band is a weird one. Maybe again the company owners are being a bit too greedy, or maybe they are on the move up or down the dividend spectrum.
Companies with this level of payout require you to look at the payout history and ask yourself these questions:
- Do they have a consistent payout ratio?
- Has the dividend grown or decreased over the last 5 years?
- Does the company have a strong profit with plenty cash available?
The reason we ask these questions is to gage just how safe this dividend is.
If in prior years we see the dividend was larger than now, could this mean the company is struggling financially? But if the dividend has been growing consistently over the last 5 years, it could mean the company is experiencing solid growth.
If the dividend payout ratio is in this band, you need to determine if the company is on the way up or the way down. If the company is stagnant you might need to make a judgement call whether the company is being greedy, or something is on the horizon.
41% – 60%
This is a healthy range of most companies that offer dividends. It is modest but still allows the company to accrue cash for future troubles and growth.
No need to be concerned about the greedy owners this time, you need to focus on the strength of the company and whether they can maintain this dividend.
Look at the 5 prior years to see whether the dividend is growing or decreasing, then dive into the financial statements. See if the company is financial strong, but most importantly, check if profit is increasing.
The last thing you want is to invest in a company with a solid dividend to find out 2 years down the line profits are tanking and that dividend you love is being cut. Strong companies pay strong dividends.
61% – 80%
Anywhere in this range is considered high because the company is expecting to payout more than 2 thirds of their earnings as dividend. This could either imply a reduction of profit, or low growth potential due to reduced retained earnings.
Companies in this range and higher are at high risk for cutting dividends, it also could impact the overall value of the stock as the high payout limits the ability to grow dividends in the future.
81% – 100%
This is an unattainable payout ratio. It is telling the shareholder the company is willing to pay almost of its earnings as dividend.
By not planning for the future or thinking about the bigger picture, the company puts itself under massive financial stress. All it would take is a slight downturn in profit to push companies in this range over the top, and eventually either cut the dividend or go into administration.
The only stocks you should invest in with payout ratios as high as this are REIT’s. The real estate industry has strict regulations to pay shareholders of these funds 95% of the profits.
Can Dividend Payout Ratio go Above 100%?
Yes, companies can pay more than 100% of their profit in dividend. But guess where that money is coming from… The retained earnings.
Companies paying dividend from their retained earnings are playing fast and loose with their financial security. It will only be a matter of time before the company finds itself in real trouble.
Stay away from dividend payout ratios above 100%
Can Companies that Make a Loss Pay Dividend?
This is what is called “Loss Making Dividends” companies can have a payout ratio less than 0%. This comes from the company have a negative EPS for the next year, as estimated by analysts.
Companies don’t want to cut dividends as they can suffer from mass selloffs resulting in a reduced share price and less market cap.
Again this dividend is being paid from the retained earnings of a company and is unsustainable. However a company that still pays dividend with a negative payout ratio is probably expecting to bounce back quite quickly.
Key Takeaways from Dividend Payout Ratios
- The dividend payout ratio is the proportion of profit paid to shareholders as dividend.
- There isn’t an optimal ratio, however we can develop opinions on a company by analysing the dividend payout.
- Fast growing companies and financially struggling companies have lower payout ratios, so it’s up to you to determine which they are.
- Slower growing companies and established companies tend to have higher payout ratios, these companies are where we get the term ‘Blue Chip Stock’.
- Dividends can be cut no matter what the ratio, it is up to the invest to determine the safety of the dividend.
Finally I would just like to add that just because a company strays from the median, it doesn’t mean it isn’t worth investing. Just look at our examples at the top…
Apple is considered to have a low payout ratio. Yet it is one of the fastest growing companies in the world with a very strong future.
On the other hand Coca Cola has an incredibly high payout ratio of nearly 90%. But Coca Cola is considered one of the safest companies to invest in having a Morningstar Safety Rating of 5 stars. Coca Cola is also a dividend aristocrat, meaning it has grown its dividend since 1963.
To find out how safe a companies dividend is you should look at these 7 risk factors.