Dividend Payout Ratio- How Safe is Your Dividend?

As a dividend growth investor, my goal is to invest in companies that will pay me cold hard cash each and every year. One quick check an investor can do to ensure the dividend safety is to check the dividend payout ratio.

But have you ever noticed that depending on where you get your information, the pay-out ratio will be different?

Depending on what resource you use, or book you read, the dividend payout ratio can be calculated a little differently. If you are like me this can be a little bit confusing when starting out.

In this article I will break down what these differences are? When I would calculate the dividend payout ratio using Earnings and when to calculate using cash flow.

We will also explore the advantages and disadvantages of each method and I will tell you which one I use and why.

What is Dividend Payout Ratio?

In the most simplistic form, the payout ratio is the total amount of dividends that is paid to a shareholder in comparison to earnings or cashflow.  This is a percentage of how much of the earnings or cashflow is left AFTER the dividend is paid.

Why use the Payout Ratio as a metric?

Over here in Engineer my freedom I don’t invest in any auld stock just because it pays dividends. We use careful analysis to make a judgement on a company that we believe will not only pay a dividend in 10 years time but will continue to grow the dividend.

Of course, we don’t have a crystal ball and will never truly know if a company will continue to pay dividends in the next 10 years but we can use data to make educated assumptions.

One of the best tools for analysing the dividend safety is by looking at the dividend payout ratio. Does the company earn enough profits to pay a dividend?  Is the payout ratio low enough to allow the company to pay a dividend even if they hit some headwinds?

The payout ratio can be a useful indicator on how safe a company’s dividend is likely to be. It can also provide some clues into the potential for growing the dividend.

Payout Ratio using Earnings

To calculate the payout ratio using earnings we need two variables. Annual Dividend Per Share (ADPS) and Earnings per Share (EPS).

ADPS need no real introduction, this is the total dividend paid each year to share holder for each share that they own. This can be paid monthly, Quarterly, Biannual or Annually. Think of this as money going out from the company.

EPS is a company’s earnings or net profit for each share of its stock. This can be calculated by dividing the net income by the number of common shares outstanding. Think of this as money coming into the company.

Payout Ratio is simply calculated by ADPS/ EPS

Example

Using AT & T and yahoo finance we can quickly see Earnings per share and the Forward Annual Dividend.

$2.08 / 1.97 = 105%

Payout Ratio using Net Income

Another way to calculate the payout ratio is by looking at the financial statements to get the total amount of dividends paid to all shareholders and the annual net income.

Payout Ratio = Net Income / Dividends Paid

The total amount of dividends can be found on the cash flow statement as shown below. (taking from morning star)

The net Income can be found on the Income statement

14.91/14.38 = 103%

Payout ratio is over 100% – Is the dividend Unsafe!

I have just shown you two ways to calculate the payout ratio using earnings and Income.  The first method using current EPS and forward expected Dividend and the second one looking at the net income and total amount of Dividends paid the previous financial year.

Both of these calculations returned over 100% which doesn’t look good for sustaining a dividend, never mind increasing it.

So why are people constantly promoting $T on twitter and blog posts?

Problems with Earnings

Accountants are tricky little buggers these days which makes it tricky for the average joe to understand what is really happening on financial statements. For example, you can have Non-Cash Earnings, Non-Earnings cash, Non cash Expense and Non Expense cash. 

I hope your head doesn’t hurt as much as mine now but an example of Non cash expense companies can include expenses today for cash payments that may not occur for decades. This can reduce reported earnings but retains cash.

Sometimes Earnings does not give you the overall picture. For example earnings could be increased by selling a fully depreciated plant.  This is a once off sale of an asset that may only boost earnings for a short period.

To complicate matters a little bit more many companies will report two different earnings figures each quarter. One set of earnings will follow the generally accepted accounting principals (GAAP) and one set will present non-GAAP financials.

Non GAAP financials will exclude the one-time transactions such as the sale of the fully depreciated plant but it is important to know there is also potential to exclude items that have a negative effect of GAAP earnings.

Cash is King!

As an investor I want to know how much cash a company has to pay its shareholders as percentage in relation to the amount of cash generated by the company.

By focusing on the operating cashflow I am excluding the sale of one-time assets and purely focusing on the cash generated by running the business. I prefer to go one step further and focus on Free cash flow which is the operating cash flow minus normal capital expenditures. Essentially this is the cashflow that is available to all stakeholders of the company.

Free cash flow gives me a more realistic view of the companies ability to pay a dividend. After all without free cash flow how can a company pay a dividend.

The formula for Free Cash Flow Payout Ratio is simply Annual Dividend Per Share divided by Free Cash Flow Per Share.

The Annual Dividend for 2019 as we saw above was 14.89. The free cash flow also from morning star is 29.23

14.89/29.23 = 50.9%

Acceptable payout Ratio

Personally, I like to see a percentage of 65% or less. This is enough for me to ensure that there is consistent room for dividend growth. As with all rules, there are some exceptions.

Some of the more mature sectors such as telecom and Utilities will have strong income streams and will be able to distribute a higher portion of their cashflow as dividends. When I am in doubt, I like to review the 10-year history of a company and if they can maintain a high payout ratio and still grow their dividend than I will likely consider them for my portfolio.

I never just look at the payout ratio in isolation, I also look for companies that are growing their earnings and dividends at roughly the same annual rates each year. This will show a nice flat payout ratio. If the payout ratio is increasing this means dividend is growing faster than the profits.

The dividend payout ratio is a useful indicator when analysing a dividend growth company. But it is only one piece of the puzzle.

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