The Payout Ratio Is Important
The payout ratio is very important to see how sustainable the dividend is. It is a critical metric for dividend investors that shows how much of a company’s income is paid to investors. The higher that number, the less cash the company is able to retain for the expansion of its business and its dividend.
The dividend ratio is what the company pays in dividends relative to earnings per share and/or cash flow per share. Let’s assume that company XYZ earns $5 per share and has a cash flow per share of $4.
If the company pays $3 per share in dividends, this corresponds to 60% of earnings per share and 75% of cash flow per share. This means that the company pays out almost all of the profits and cash flow in dividends.
What happens if the result falls? Given the same dividend, of course, the payout ratio increases, perhaps to over 100%.
If the company is to continue with the same dividend or increase, it means that parts of the dividend are financed by loans or previous retained earnings.
Over time, of course, such a situation is unsustainable: in the long run, no more dividends can be distributed than what earnings allow.
Therefore, dividends are often cut among the companies with the highest payout ratio. And a cut in dividends is often severely punished in the US and UK by the fact that the share price falls.
The fact that the dividend rate is high is often due to the fact that the dividend is increased more than the results, that earnings have fallen, or a combination. In companies that have financial problems, dividend yields are often high.
A research note from the fund company GMO in the summer of 2012 looked more closely at accumulated returns in shares that have a higher dividend per share than earnings per share:
As evident from the above figure, a payout ratio of more than 100% indicates a poor future return.
American Santa Barbara Asset Management, a company that mainly focuses on dividend stocks, took a closer look at this and divided dividend stocks into five parts based on the payout ratio (US stocks).
As it can be seen in the above figure, the stocks that pay “moderate” dividends are those that show the relatively best return:
The best quintile is number 3: that is, those who pay neither much nor little of the profit. The worst are quintile 5, those who pay the most, and quintile 1, those who pay the least. Of the five quintiles, only numbers 3 and 4 give better returns than the S&P 500, ie those with a “moderate” dividend yield.