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Growth Stocks? Value Stocks? Understanding The Role Of The Dividend Payout Ratio

Dividend Investing 101 | Dividends Explained

dividend payout ratioA recent reader questioned the validity of a dividend aristocrat as a growth stock. His argument was whether or not you could find a growth stock among those dividend aristocrats. He asked, why invest in a dividend aristocrat because after 25 years of consistently rising dividends, how much growth could there be left in the shares?

The question, like most, begs for a little further examination. It made me dig into some questions? When does a growth stock become a value play? Can a dividend aristocrat be a growth stock? Or, is it a value stock by its very nature? And, what role does the dividend payout ratio play in our determinations?

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. Last year, of course, the S&P 500 Index saw a 13% gain, and it is set to make a comparable run here in 20113 as well.

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 59 dividend aristocrats in the S&P 500 index, many have seen year over year share price growth of over 13% 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.

Many dividend investors tend to balk at investing a company that pays out more than 50% to 60% of its profits in dividends. Keep in mind though that this is a rule of thumb. It does not apply to some investments like real estate investment trusts which must by law distribute 90% of their profits to investors.

A company that has a dividend payout ratio of greater than 50% 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 mea 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.

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