Even the best investment strategies require ongoing maintenance and adjustments to stay ahead in a world with volatile markets and fluctuating economic conditions – but how can investors differentiate between normal market activity and troublesome indicators? One of the solutions is the dividend payout ratio.
In regards to dividend stocks specifically, the dividend payout ratio is an extremely useful indicator of a company’s dividend health because you can calculate how much of its net revenue is paid out to shareholders, compared to how much of the company’s income is held onto for debt repayments and funding internal operations.
To determine whether a company’s dividend payout ratio is within safe ranges, it’s important to avoid the common mistake of equivocating the dividend yield with the dividend payout ratio. A dividend yield represents the simple rate of return paid out to shareholders (e.g., a stock trading at $60 per share with $6 annual dividends has a dividend yield of 10%), while the payout ratio examines the relationship between a company’s net income and dividends paid out to shareholders.
With this important distinction in mind, here’s everything you need to know about safe dividend payout ratios:
What is a Dividend Payout Ratio Formula?
To calculate the dividend payout ratio of a stock, simply divide the annual dividends per share by the company’s earnings per share. A company’s income may not be easy to find immediately, but with a little digging, you’ll be able to locate this information in the company’s balance sheets.
For new investors, analyzing a stock’s dividend payout ratio is typically preferable to relying solely on the dividend yield because this equation offers a more accurate glimpse at a company’s financial well-being. In other words, the dividend yield might obscure times when a company is operating at a short-term loss to fulfill dividend obligations to shareholders, while the dividend payout ratio lets you see just how much a company is paying out to shareholders, relative to its earnings.
What is the Average Dividend Payout Ratio?
Average dividend payout ratios are dependent on a variety of factors, including the timeframe (which year/quarter), the index, industry, and individual companies. For this reason, there is no universal “average” dividend payout ratio, though there are typical ranges that investors should be aware of.
For instance, real estate investment trusts (REITs) maintain their special tax exemption statuses by distributing 90% of their earnings to shareholders, but 90% would be a terrifyingly dividend payout ratio for say, a tech company (because this means only 10% of the company’s income is reserved for maintaining and expanding their operations).
For many years, Apple didn’t pay out dividends to shareholders, which made their payout ratio effectively 0%. Generally speaking, the “average” dividend payout ratio hovers closer to the 30-40% range, which suggests that companies reinvest an average of 60-70% back into their own operations to nurture long-term dividend growth potential.
What is a Safe Dividend Payout Ratio?
As mentioned previously, sometimes extremely low (0-10%) or extremely high (80-90%) dividend payout ratios are the norm for a particular type of company or industry. If you’re interested in expanding your dividend portfolio to maximize growth, then you should consider investing in stocks with payout ratios of 30-50%.
A common mistake newer dividend investors might run into is making the [wrong] assumption that higher dividend payout ratios are the better investments. On the contrary, a company with a high dividend payout ratio (55% or higher) is reserving less cash for expansion, which suggests its share prices could stagnate in the near future. Furthermore, a high payout ratio may be unsustainable in the long-term, which could force a company to slash dividends in order to balance its earnings and payouts to shareholders.
Meanwhile, a low payout ratio (15-35%) suggests the company is focused on innovation and growth, which could lead to both higher share prices and higher dividend payouts in the future for investors who are willing to wait it out.
Understanding Growth Stocks vs Value Stocks
Investopedia defines a growth stock as a stock whose share price grows at a faster rate than the overall stock market.
Conversely, a value stock is the ying to growth stocks’ yang. Value stocks are often undervalued when compared to the company’s financial metrics. Investors often find that value stocks have a higher dividend yield, lower price to book ratio, and often a lower price to earnings (PE) ratio than growth stocks traditionally.
Can A Dividend Aristocrat Be A Growth Stock Too?
Yes, a dividend aristocrat can be a growth stock also, but it may be unlikely. They are more likely to be a value stock and a blue chip company. Out of the 53 dividend aristocrats in the S&P 500 index, many have seen year over year share price growth in recent years. While we may not consider strong dividend payers as high growth companies, the possibility is still out there for those companies to provide both income and capital appreciation to shareholders.
How The Dividend Payout Ratio Fits In
Just because a company is a value stock does not mean that there isn’t room for its share price to grow. A company’s dividend payout ratio tells the story and of its potential to grow and provide investors with a safe and secure dividend.
The dividend payout ratio is simply the total amount of net income or profits that a company pays out to shareholders in the form of dividends. Simply divide the total amount of dividends (cash and stock) paid out to shareholders by the company’s total profit to get a percentage. You can find these numbers in the company’s Annual Report.
As mentioned above, a company that has a dividend payout ratio of greater than 55% may be an indication that the companies are not plowing back enough profits into the business to invest in research and development, new property, plant, and equipment, and the like. It could be a warning sign. Conversely, a low dividend payout ratio for a stellar company could be an indication that the firm has the ability to increase dividends in the future without too much impact on their business.
Are all dividend aristocrats growth stocks? No, of course they are not. But, that does not mean that dividend aristocrats do not have room to grow their share prices at a decent rate. These tried and true companies may not be the next stock to shoot up 20%, 30%, or more in a year, but they also have the capability thanks to their dividend payout ratios to not only continue raising their dividends year in and year out but also reinvesting their profits for continued growth.
Final Thoughts on Dividend Payouts
Although the dividend yield is a popular metric for determining whether a stock is worth investing in, it’s crucial that investors take the payout ratio into account as well. By focusing solely on one or two factors, your investment strategy could take a hit because you didn’t approach each stock in your portfolio with a long-term lens.
On the flip side, an investor who analyzes both the dividend yield and the dividend payout ratio (among many other factors) are much better off, thanks to a careful strategy of examining both the relationship between the dividends and share value and the relationship between the company’s earnings and annual dividend payouts.
Ultimately, it’s up to you to decide whether you want to take more of a value investing approach or an dividend growth investing approach. There’s no one-size-fits-all solution to this dilemma, but outlining your biggest investment goals can help you decide which dividend metrics you should focus on when it comes to managing your own portfolio.