Understanding The Dividend Payout Ratio — And Why It Matters…
I love hearing from my High-Yield Investing subscribers. Any time I get an email from a reader, whether it’s in the form of a question, some constructive feedback, or simply a success story — it reminds me that we’ve gained quite the loyal following over the years.
One of the most common questions I get has to do with payout ratios. The question usually goes something like this…
What is a dividend payout ratio?
Why do the dividend payout ratios listed in High-Yield Investing sometimes differ from the payout ratios I’ve found on various financial web sites?
These may sound like simple questions, but it’s worth addressing for a wider audience. Because, as you’ll see in a moment, successful income investing goes far beyond simply buying a stock with a high dividend…
Dividend Payout Ratio, Explained
The dividend payout 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%.
Payout ratios may vary on different financial web sites. One of the reasons for the discrepancy is that the dividend payout can be calculated as a percentage of cash flow instead of reported earnings. The payout ratios of securities such as real estate investment trusts, limited partnerships, and telecom firms can seem deceptively high if they are based on earnings instead of available cash flow. That’s because these companies typically have very high non-cash depreciation expenses, which reduce earnings but don’t affect the cash flow available to shareholders.
When writing my High-Yield Investing newsletter, I take great care to mention the most appropriate payout ratio for each particular security we mention. In many cases, we’ll cite payout ratios as a percentage of available cash flow instead of earnings. We calculate this data by reviewing each firm’s latest annual financial statements.
Again, because earnings include a number of non-cash changes, including depreciation, the use of cash flow figures usually provides a more accurate indication of each firm’s ability to continue to meet its dividend requirements. However, since we often use cash flow data instead of earnings, the payout ratios we reference may differ from what you’ll find on other financial web sites.
No matter how you calculate payout ratios, the general rule here is the same: The lower a stock’s payout ratio, the better. The reason for this is simple. Firms with low payout ratios generally have more room to raise their dividend payments in the future. Low payout ratios also provide an extra level of security. This is because even if the company’s earnings were to decelerate, the dividend would remain safe for a period of time.
Bottom line, it’s important to understand payout ratios: what they are, how they’re calculated, and what’s considered a high or low payout ratio. Not only does it explain some of the discrepancies you’ll find from different information sources, but it can also make a huge difference in determining whether an investment is right for you when the time comes to decide whether to buy or sell.
P.S. Regardless of your risk tolerance, goals, or ideal time frame, income payers deserve a place in every portfolio. And Over at High-Yield Investing, we cover some of the best income opportunities the market offers.
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