We’ve mentioned the payout ratio before. It’s a relatively simple concept that says a lot about a company, which is why a lot of investors (income seeking ones in particular) pay close attention to it.
We recently picked out the seven companies most likely to raise their payouts and also included the payout ratio as a vital component of the dividend health check we recommend you take regularly. But it helps to understand the intricacies of this simple ratio and how it can be used to judge a company’s financial strength.
Here is everything you need to know about the dividend payout ratio:
What is it?
A dividend payout ratio is the amount of dividend paid per share divided by the earnings per share. The payout ratio is a quick breakdown of how much money the company paid to investors in the form of dividends and how much it held back on its books to reinvest in the company.
If a company earns $10 per share in a year and decides to reward investors with a $2 dividend, the payout ratio is 20% ($2 / $10).
The ratio can tell you a lot about the way the company managing money and can also help you estimate the state of the company. It might even be a helpful indicator of future growth. You see, for some companies there are simply not a lot of opportunities to invest within the business. A coal mining firm or a public utility, for example, doesn’t need all the cash it makes in the year because it doesn’t have anywhere to invest it. So, the ratio may be higher for slow growth companies. On the other hand, a quick mover and fast-growth company will have a much lower payout ratio. Google, for example, doesn’t pay a dividend at all because it needs all the money it can get to reinvest into the business. Google’s payout ratio is effectively 0%.
Some companies do not need the money they have lying around in their bank account and can afford to give dividends, but they don’t. Apple under Steve Jobs, for example, kept hoarding cash even when the cash was essentially earning very little interest and wasn’t being deployed anywhere. Tim Cook changed that policy and now Apple’s payout ratio is nearly 26%. So, the payout ratio can tell you a lot about the shareholder-focus and the management style at the top of a company. In other words, management has the final say over how much money is paid out to shareholders. A generous dividend policy could signal that management is optimistic about growth, while a low payout ratio could indicate management is saving up for a big acquisition or a rainy day ahead.
Finally, the dividend payout ratio can help you calculated the company’s sustainable growth rate. The opposite of the payout ratio is the ‘retention ratio’. Also called the amount of money the company reinvests into the business from earnings each year. When you multiply the retention rate with the return on equity (ROE), you get a percentage estimate for future growth rates. So, if a company has a ROE of 30% and a retention rate of 40%, the future growth rate is likely to be close to 12% (30% x 40%).
How much is too high?
There’s no set point at which a dividend becomes too high. It boils down to your personal judgement about the company’s prospects and the historical dividend policy. A ratio around 95% should have you considering if the dividend is under threat when the earnings are disappointing. Or a ratio above 100% should make you wonder if the company is chewing into its cash pile. The company could be borrowing money to pay shareholders a stable dividend.
But if you find that the company has a plan for future growth and a reasonable dividend policy it means you’ve found a great income earner.
How much is too low?
Again, there is no minimum bar for a dividend payout ratio. Fast growing tech companies pay no dividends at all. Amazon, for example, has never even considered a dividend. But a maturing company with a low payout ratio may be a sign of unjustified conservativeness at the management level. Sooner or later, company managers realize they have too much cash lying around losing value from inflation. Or an activist shareholder convinces them to release the purse strings. A company with a massive cash hoard and low growth prospects could be a good buy for future dividend growth.
Often, the dividend payout ratio is a lot more informative than the dividend yield. It can tell you a lot about the present state of the company’s finance. It can also tell you about the management style the company has adopted. A ratio that is either too high or too low isn’t necessarily a red flag. But it should raise some questions. If you can answer these questions satisfactorily, you may have found a great dividend investment opportunity.