When it comes to picking the best blue chip dividend-paying stock, all that really matters is dividend size, right? Wrong!
As a blue chip investor, you know how important it is to do your research. And you also know how much data is available. Even well-trained investors can find it overwhelming.
If dividends are your priority, then you can’t just look at the size and frequency of a company’s recent payments. You also need to look at the dividend payout ratio when you’re analyzing stocks. Otherwise, you could end up buying shares of a sinking ship that is cleverly masked with unsustainable high-yield dividends.
What Is a Dividend Payout Ratio?
The dividend payout ratio is a very simple statistic. It shows how much of a company’s net income gets paid out as dividends to shareholders. For example:
- If a company earns $10 million and pays out $5 million in dividends, the payout ratio is 50%.
- If a company earns $50 million and pays that same $5 million in dividends, their payout ratio is only 10%.
- If a company has a 100% payout ratio policy, all of its retained earnings go to shareholders. The company keeps none of its earnings.
The dividend payout ratio is closely related to the dividend coverage ratio, which measures the relationship between dividends and earnings on a per-share basis. This article from Modest Money explains the dividend coverage ratio in more detail.
In either case, it looks like relatively simple math, but the implications of a company’s choice to have a higher or lower dividend payout ratio (or coverage ratio) can be complex.
What Is a Good Dividend Payout Ratio?
Wouldn’t you want your company to pay out all of its profit to shareholders, providing a huge dividend instead of greedily holding back earnings? While a 100% dividend ratio sounds like a great ideal, unfortunately, getting cash back from a public company isn’t as simple as trying to make a friend pay back a loan.
Remember that you own the stock already, and a dividend payment just transfers value from the share price to your wallet. That’s why when a company worth $10 per share pays out a dividend of $2 per share, the price should theoretically drop to $8. Though a dividend check feels like a victory, it’s more of a balance transfer, not found money. You’ll find that a low dividend payout ratio isn’t necessarily a bad thing, and a high ratio is often bad news for shareholders.
Benefits of Low Payout Ratios
In many situations, you should be happy to find low payout ratios. If you’re investing in a company, you’ll want its leaders to make wise decisions with the company’s profits. When a company pays a dividend, the profits are no longer at the disposal of the company. Holding on to some cash, instead of paying everything out, allows a business to:
- Invest in more efficient technology and machinery
- Hire additional staff and expand skill sets
- Prepare for economic uncertainty
- Operate effectively in bad economic environments
- Maintain consistent, stable dividend payments over short- and long-term periods
- Take advantage of high-growth opportunities like new product lines
- Consider attractive acquisition properties
- Invest in affordable real estate or new facilities
When a company retains a large percentage of quarterly or yearly earnings and uses the money to invest in growth, you can expect the value of the stock to climb. And that increased value will be more lucrative than a slightly higher dividend payment. But companies that have a policy of overpaying dividends don’t have enough liquidity to take advantage of such opportunities. A low payout ratio, therefore, saves the company from these undesirable options:
- Passing up valuable opportunities and losing out on the potential gains
- Selling debt bonds, which the company would need to repay along with any accrued interest
- Selling more equity shares, which lowers the value of your shares
- Raising capital by suspending dividends altogether
In short, lower payout ratios allow companies to consistently reward investors and maintain valuable growth. In the end, this business practice should lead to a continually rising stock price, providing more long-term value than quick bursts of higher dividend payments. Plus, you won’t be subject to fluctuation – or cancellation – of your dividend payments.
If you want your dividend-yielding company to have enough money to reinvest for decent growth and to maintain a stable dividend, look for payout ratios less than 50%.
Benefits (and Cautions) of High Payout Ratios
Of course, a high payout ratio seems to have an obvious benefit: a nice big check one to four times per year. And that payout is a more legitimate cause for celebration if it doesn’t come at the expense of hindering growth. What if you invested in a large and efficient company that generated huge piles of cash, but the business had already achieved market saturation? The company won’t benefit as much from hoarding cash when no further growth opportunities exist, so large-value stocks with little expected growth opportunities are good candidates for a high payout ratio.
A large-value company should still exhibit some discretion to avoid trouble in a recession or from an unexpected hit to its business model, but these businesses can still afford a much higher payout ratio than comparably smaller companies.
High payout ratios have more obvious benefits, making due diligence more crucial. If you see a large-value company that has significant cash reserves but doesn’t have room for growth, make sure they either maintain a high dividend payment ratio or have a reason to hold on to that cash. If they don’t justify the cash reserves, be wary about investing in that company. It’s possible that management has insider knowledge of some future turbulence that will hurt the company, or perhaps management wants to pay its cash out to themselves in the form of higher bonuses.
Another Dividend Payout Ratio Consideration
In Does Dividend Policy Foretell Earnings Growth? Robert D. Arnott and Clifford S. Asness present one more aspect to consider. Going against the grain, these two researchers found a historical link between high payout ratios and high future earnings growth. Similarly, they found that low payout ratios were linked to low future earnings growth. These conclusions seem to fly in the face of the idea that low payout ratios allow a company to stockpile money for future growth opportunities. So why might a high payout ratio lead to future growth in earnings?
- When managers have less money at their disposal, as is the case with higher payout ratios, they must be much more careful to select only the best growth opportunities, rather than spend the company’s money aimlessly without much consequence.
- High payout ratios may also signal management’s confidence in the company. They foresee blue skies ahead and therefore raise the dividend payout ratio in advance.
As examples of Arnott and Asness’s findings, certain low-growth industries, like utility companies, typically have high payout ratios. The technology sector, on the other hand, is historically a high-growth industry, so these companies are prone to paying out much lower dividends ratios. This argument is worth considering when you make your stock picks, but it’s possible that companies simply choose their payout ratios based on their perception of the growth opportunities available to them.
When choosing a dividend-paying stock, don’t just look at the dividend frequency and rate. You must consider the payout ratio. Accept a low payout ratio for a stable company with room for growth, or take a higher payout ratio with the caution that these stocks won’t have as much opportunity for growth.
Ultimately, the most important thing is to make sure you do your due diligence on the sustainability of a company, including an analysis of revenue and profits, to ensure there will be an increasing pot of money out of which the company can draw its dividends.
Do you invest in dividend-paying stocks? What do you typically look for in dividend payout ratios?