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| Advice
to the Yield-Hungry: Check Out Payout Ratios |
Published: January 1, 2006
Low payout ratios leave more
room for dividend increases and share price gains
Yield-hungry investors are sometimes tempted to look no further than a
stock's current dividend yield. At first blush, a stock like investment
banker Kent (KENT, $2.45) with its 12.9% yield looks a lot more enticing
than one like one of my portfolio holdings -- Holly Energy Partners
(HEP, $36.89), which yields 6.4%.
But looks can be deceiving. In fact, when it comes to dividend-paying
stocks, they can be downright dangerous. Investors love rules of thumb,
and one that applies to the dividend universe is that the higher the
yield, the greater the risk of the dividend being cut or even wiped out.
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Look at computer programmer TSR
Inc. (TSRI, $4.65), which a few short months ago boasted a double-digit
dividend yield of 10.5%. Today, its yield has been cut in half along
with its quarterly dividend payout. Meanwhile, the stock has declined
about –50% in the past year alone.
How do you protect yourself from such high-risk temptations? One handy
test is to examine each company's payout ratio. This ratio
measures a stock's annual dividend payment as a fraction of its
earnings. It tells you what portion of its earnings a company is paying
out to shareholders. A company that earned $1 per share in profits over
the past year and is now paying out 60 cents a share in annual dividends
has a payout ratio of 60%.
The problem with stocks like TSR and KENT is that they pay out more than
they earn. A quick look at any free financial website like Yahoo Finance
will show you that both of their payout ratios are over 100%.
Real estate investment trusts, limited partnerships, or Canadian income
trusts typically sport high payout ratios because they are required by
law to pay out most of their profits to shareholders. Their payout
ratios can also seem deceptively high if you base them on earnings
instead of available cash flow. Nonetheless, as a general rule,
companies that sport payout ratios of more than 100% should be examined
carefully, as danger may lurk ahead.
Apart from these special situations, happiness for the yield-seeker is
finding a high-yielding stock with a low payout ratio.
Why? The reasons are plentiful, but for the income investor, there's one
big reason to look for a stock with a low payout ratio -- it shows the company
has plenty of room to raise its dividend payment in the future.
And while you're waiting for the firm's dividends to increase, you can
rest assured that even if the company's earnings turn south, the
dividend will more than likely be safe.
Now is an opportune time to look for stocks with low payout ratios. As
you can see from the accompanying chart, the average payout ratio of
stocks in the S&P 500 Index is an estimated 30%. This is the lowest
point it has been in 65 years. That means income investors should have
lots of high-quality options to choose from when looking for stocks with
low payout ratios.
Why have payout ratios reached historical lows? The reason is simple --
in recent years dividend growth hasn't kept pace with earnings growth.
Dividend-payers in the S&P increased earnings an estimated +20% last
year but only boosted their dividends about 12%, according to Standard
& Poor's.
Finding stocks with low payout ratios is a cinch. An initial search gave
me over 3,800 stocks with payout ratios of 55% or less for the past 12
months. However, the tricky part was finding low payout stocks that also
sport above-average dividend yields. When I raised the bar to select
stocks yielding at least 5%, the list boiled down to just 47 stocks.
To ensure that these high-yielding stocks with low payout ratios really
had the earnings power to fund future dividend increases, I then added
one more hurdle. I only selected stocks that had grown earnings at the
rate of +20% or better over the past 12 months.
In sum, I used three tough tests to find high-yield stocks poised for
future dividend increases and share price gains:
-- Dividend yield of at least 5%
-- Dividend payout no higher than 55% of earnings for past year
-- Earnings growth in the past year of at least +20% versus the year
before
After incorporating these three criteria into my proprietary scanning
tool, my original list of 3,800-plus stocks contracted to just a half
dozen -- the crème de la crème of safe dividend payers and potential
dividend growers. To view the names and ticker symbols of these six
high-yielding, low-payout ratio stocks, please visit one of the links
below . . .
Important
Note: Throughout the remainder of this article, editor
Carla Pasternak provides an analysis of six high-quality, high-yielding
stocks with low payout ratios. However, in order to view the remainder
of this article, you'll need to subscribe to our premium income-oriented
newsletter -- High-Yield Investing. After you
subscribe you'll receive immediate access to this full article, as well
as our monthly High-Yield Investing newsletter and a host
of additional premium content. Please visit one of the following links
to continue...
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