Dividend investing is one of the most common forms of income investing. The idea is to look for stocks that pay high dividends and offer stable growth. In doing so, not only does the investor enjoy growth in share prices, they receive a quarterly or annual dividend payment that transfers some of the company’s wealth back to their shareholders.
With the opportunity to cash in and enjoy value growth, dividend investing is popular, not only among expert investors, but also to the greenhorns of the investing community.
Beginner investors often make the mistake of chasing high dividends without understanding exactly what they are, and the dangers of a high dividend payout ratio can be a warning sign of.
What Are the Dividend Payout Ratio and Retention Ratio?
Investors often use various ratios as a way to determine the quality of an investment. Two key ratios for investors focused on stocks that provide dividend payments are known as the dividend payout ratio and the retention ratio.
Dividends are paid out of net earnings. After all, if dividend payments accounted for more than the company generated in profits, it would have to tap its cash reserves or go into debt in order to pay declared dividends to investors.
The dividend payout ratio and retention ratio give investors an at-a-glance view of how the company divides its income. The percentage of earnings the company pays to investors is the dividend payout ratio, and the percentage of earnings kept in order to fund the future growth of the company is the retention ratio.
For example, if company XYZ generated net income of $100 million and paid $20 million to investors — choosing to hold $80 million in retained earnings to fund growth — the dividend payout ratio comes to 20% and the retention ratio is 80%.
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What Is a Good Dividend Payout Ratio?
As an investor, you want the highest amount of dividends you can get your hands on, right? Well, not exactly.
Investing is all about putting your money to work, allowing time to pass and compound gains to work their magic. It’s important to keep in mind that dividends are a transfer of wealth, not free money.
When a company pays a dividend to its investors, its stock becomes less valuable. A stock with $100 million in cash on its balance sheet is generally more appealing than a company with $80 million.
So, dividends are a give and take, and focusing solely on high dividends can cost you tremendous value in the long run.
So, what exactly is a good dividend payout ratio?
The answer to that question has more to do with your financial goals, comfort with risk, and investing strategy. For most dividend investors, a dividend payout ratio somewhere between 30% and 55% is compelling. Payout ratios below 30% are considered low and above 55% are considered high.
Nonetheless, there are pros and cons to both low payout ratios and high payout ratios.
Low Payout Ratio Pros and Cons
Who wants a low dividend payout ratio? Aren’t you investing to earn money? You might be surprised at the benefits a low dividend payment may have on your investment portfolio’s total returns.
Pros of a Low Payout Ratio
There are several benefits to a lower payout ratio. There are several good reasons for a company to retain more of its income rather than paying our large dividends to shareholders. Some of the most important to consider include:
- It Costs Money to Make Money. At first glance, seeing a company’s earnings either not being shared at all or only being shared in a small way seems like a bad thing for investors. However, it costs money to make money. Publicly traded companies on the leading edge of innovation in their fields spend massive amounts of money on research and development, which results in higher-value assets and a higher probability of market dominance ahead. As a result, seemingly costly innovation often becomes the goose that lays the golden eggs down the line.
- Balance Sheet Improvements. A strong balance sheet is important for any publicly traded companies. By choosing to make smaller dividend payments, or choosing not to make dividend payments at all, companies have the ability to bolster their balance sheets. Building up cash reserves or paying down costly debts improves the company’s ability to weather a downturn, which leads to stronger investor interest and ultimately higher stock prices.
- Acquisitions. Acquisitions are a costly but potentially valuable proposition. By purchasing smaller companies in the same field, larger companies have the ability to use their connections to reduce costs at the smaller company while bringing their products, technologies, and audience in house, greatly expanding revenue potential. Money held back from a company’s earnings that’s used for accretive acquisitions is often money well placed.
Cons of a Low Payout Ratio
Although a low payout ratio comes with its perks, there are a couple of drawbacks to a company’s dividend payout ratio being low.
- Low Dividend Payments. Low payout ratios generally relate directly to low dividend payments. If you’re investing with the goal of earnings stock dividends, a low payout ratio may not be a good prospect for you.
- Possible Sign of Financial Struggles. Dividend payments aren’t a requirement among publicly traded companies. In fact, there are plenty of them that simply don’t pay dividends at various levels of success. Oftentimes, companies have a low payout ratio because they’re investing the majority of their net earnings back into growth. In other cases, companies simply don’t make enough money to afford to pay dividends. As such, before investing in a company with a low dividend payout ratio, make sure to research its balance sheet, cash flow statement, and other financial statements to ensure the company is built on a strong financial foundation.
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High Payout Ratio Pros and Cons
There are obvious benefits to a high dividend payout ratio. After all, a high payout ratio means that you’ll enjoy high dividend payments. But you’ll find thorns on every rose, and a high payout ratio could lead to similar pain.
Pros of a High Payout Ratio
There are several reasons investors get excited about a high payout ratio. Some of the most significant include:
- High Dividend Payments. The most obvious reason some investors look for high payout ratios is that high ratios directly equate to high dividend payments. If your primary goal is to generate dividend income, a high payout ratio is appealing.
- Financial Stability. In most cases, a high dividend payout ratio is a sign of financial stability. The company doesn’t have to pay dividends to its investors at all. So, if it chooses to pay a high dividend, it usually has the strong balance sheet and compelling cash flow to back it up.
- Potential for Reinvestment. Old school investors will tell you to buy dividend stocks and reinvest your dividend payments in order to achieve compelling total returns on long-term investments. The larger percentage of total net income you receive in dividend payments, the more money you’ll have for dividend reinvestments.
Cons of a High Payout Ratio
Although a high dividend payout ratio is appealing for many reasons, it’s also concerning in some cases. There are a few red flags to watch out for before investing in a stock that offers a high payout ratio:
- Market Saturation. Oftentimes the leaders of a saturated market will make seriously high dividend payments, offering up the vast majority of their net earnings to investors. Once a company comes to dominate a market that it largely has control of, it is comfortable sharing its wealth with shareholders in a big way. Sure, that’s exciting — but market saturation also means tapped growth potential. If you already control a market so completely that you can’t find a compelling use for reinvesting your excess income, there’s not more market share to take from competitors. You only take part in overall market growth, so you don’t have the momentous growth opportunities smaller companies have. As such, a high payout ratio generally comes with little opportunity by way of share price appreciation.
- Failure to Innovate. If a company doesn’t hold enough of its net income back to fund innovation, its failure to stay ahead of the curve could lead to its demise. Even established companies fall when innovation is lacking. Think of BlackBerry — the smartphone pioneer has become nothing more than a lagging tech stock, losing tens of billions of dollars worth of market capitalization over the past decade. A high dividend payout ratio may be a sign that a dominant company is getting too comfortable and may soon lose its position as a leader in its market.
- Recessions Happen. Economic recessions and bear markets have been commonplace throughout history. Past earnings aren’t always indicative of future earnings, and economic fluctuations often play a major role in that fact. If a company fails to hold enough of its net earnings back during the good times, its balance sheet may not be strong enough to make it through a recession without significant losses to its stockholders.
Other Considerations to Think of When Investing for Dividends
If your goal is to generate income by investing in dividend stocks, you’re on the right path. Countless people have followed that path to wealth in the past, and plenty more will do the same in the future. However, the dividend payout ratio isn’t the only number investors should focus on when investing for dividends.
The dividend yield is another ratio investors use to gauge the quality of dividend payments an investment in a stock will provide. The dividend yield compares the total amount of dividends over the course of a year to the price an investor pays for a stock.
High dividend yields are often the goal. However, a high yield can also be a warning sign. For example, energy companies are known for paying compelling dividends. When oil prices are up and these companies are doing well, their dividend yield shrinks as their stock price grows. Conversely, when oil prices are down and these companies are struggling, the dividend yield increases as the stock price shrinks.
At these points, many in the energy sector may struggle to keep dividend payments high in order to attract new investors. However, the high dividend yield could be a trap, driving new investors into a diving stock.
So, although you’ll want to be paid relatively high dividend yields, make sure to do your research to ensure that the high yield is not the result of economic inefficiencies in the company or declines in the sector as a whole.
Sometimes you’ll become interested in an investment opportunity because of high dividend payments, only to find that its dividends begin to shrink in the coming months.
Ultimately, dividend investing requires research, not only into the dividends provided by the company, but how sustainable those dividends are. The higher the dividend payout ratio and dividend yield, the higher the probability of dividend sustainability issues.
Do your research, not just by looking at dividend payout ratio and dividend yield, but by looking into the company’s saturation of its market, innovation, and other factors that will lead to continued growth and the continued ability to pay compelling dividends.
Total Rate of Return
A high dividend payment doesn’t always mean that you’ll experience a high return. For example, a dividend yield of 3.5% or higher on a stock is considered high. If that 3.5% is added to another 6.5% of stock price appreciation over the course of a year, the total annualized rate of return on the investment would come to 10%.
However, high dividend payments are often coupled with slow or no share price appreciation. If you invest in a stock with a high 3.5% dividend yield, but the stock price only grows 2% annually, your total annualized rate of return is 5.5%, lagging far behind the average market growth rates of the major benchmarks. You’d be better off investing in low-cost index funds.
Form of Dividends
Dividends come in two forms. They will be paid in either cash or stock. For example, if a company pays a cash dividend, the total amount of dividends will be divided by the total number of outstanding shares and paid accordingly.
If the dividend is a stock dividend, the company will announce how many shares will be given to each shareholder per share owned. For example, a company may offer a dividend of .05 shares per share owned, representing a dividend yield of 5%.
However, be careful with dividends that are paid in stock. Oftentimes, cash payments will not be offered for fractional shares. As a result, if you don’t own enough shares to earn a full share as your dividend payment, you may not receive a dividend payment at all.
There are two purposes for investing in dividend stocks. Either the investor is seeking income, with dividends providing quarterly or annual payments they can count on, or they’re looking for long-term growth generated by reinvesting dividend payments.
If you don’t have an immediate need for the additional income that dividends provide, you have the opportunity to harness the power of compounding gains by reinvesting all or a percentage of your dividend payments into the purchase of new shares. Most brokerages allow you to do this automatically, turning cash dividends into additional shares with each payment, without you ever having to lift a finger.
Preferred Stock or Common Stock
Before following a dividend investing strategy, it’s important that you do your research to get an understanding of the benefits and drawbacks offered up by preferred stock and common stock.
Dividends are paid differently for different types of stock. For example, with common stock, dividends can fluctuate up or down or stop completely at the company’s discretion. With most classes of preferred stock, dividends are predetermined and will stay fixed as long as you hold the stock.
General Due Diligence
Regardless of how significant a company’s declared dividend is, it should not be the sole reason for an investment in any stock. Before making an investment, it’s important to do your general due diligence.
In other words, ask yourself this simple question, “Would I buy this stock if it didn’t offer dividends?” If the answer is “no,” move on and look for a better opportunity.
Dividend Investing Has Its Time and Place
Dividends are a give-and-take. Most stocks that are known for compelling dividend payments are known for relatively slow, steady growth. As a result, a high dividend stock allocation is great during bear markets.
On the other hand, during bull markets, dividend stocks don’t experience the dramatic growth seen in the overall market. So, when the market is hot and stock prices are on the rise, you may want to reduce your exposure to dividend stocks in order to free up funds to take advantage of the figurative running of the bulls on Wall Street.
Dividends are an exciting concept. If a stock sees compelling share price appreciation and pays dividends, investors get to have their cake and eat it too. However, there aren’t many stocks on the market that are known for both compelling dividends and compelling price growth.
Although dividend stocks are a great option for a well balanced portfolio, only focusing on dividends could lead to stagnant growth — or worse, losses.
When making an investment, make sure to take a comprehensive look at the company, gauging its financial stability, its past and future pipeline of innovation, and its drive either to become the leader of its industry or to maintain its crown.
Dividend investing has made many millionaires, and will make plenty more in the future. Making educated investments and following a dividend investing strategy may be your ticket to being the next stock market success story.