As a dividend growth investor, you can look at several metrics to evaluate the performance of a stock over the last months, years or even decades.
This is very important as you want to find companies that will generate a huge ROI (return on investment). It’s not sensible to take the risks of the stock market just to receive 1-2% for your investment as you can easily get similar results with a risk-free savings account.
I’ve already discussed two of those parameters in a recent post about dividend growth ratio and dividend yield. However, there is one thing that is even more important to look at.
I’d always prefer a secure stock over a high return stock. Losses are worse than low returns. If you don’t believe me, you may believe in the two investment rules of the legendary investor Warren Buffett:
Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
Today, I want to show you one metric that helps me to find secure dividend growth stocks. There are others things you want to look at, but for me, this number is the entry point in my evaluation.
Without further ado, let’s dive in.
How to calculate the payout ratio?
To make it simple, the payout ratio tells you how likely it is that the company can continue to pay its dividends. You can use two methods to calculate the payout ratio:
No. 1.: Payout Ratio = Dividends per share / Earnings per share
No. 2: Payout Ratio = Total dividends paid / Net income
Both of these values are percentage values, so you need to multiply them by 100 to get it in a more readable format. Now you know how to calculate it, but what is the payout ratio?
What is the payout ratio?
The payout ratio tells you how likely it is, that a stock can increase or maintain its dividend. What is a good value for this metric? I try to keep the payout ratio below 75% for all my investments but I make some exceptions.
Let’s use an example.
Company A pays out $9 in dividends (per share) and its earnings are $10 per share. With the calculation above you can easily see that the payout ratio is 0.9 or 90%.
What does this mean?
Let’s say the company decreases its earnings by 10% which is not totally unlikely. The earnings per share are then just $9 now. Which results in a payout ratio of 100% if the dividend stays the same. But the company can’t increase its dividend. Well, and this is what dividend GROWTH investing is all about. Even worse when the earnings drop by 15%. Then the company has to cut its dividends.
75% payout ratio means that the earnings can drop by a quarter and the company is still able to keep the dividend at the same level than last year. The lower the better. But this is a good maximum.
Variations of the payout ratio
There are some variations and ways to look at the payout ratio. You can calculate it with the cash flow instead of the net income. Many people argue that the cash flow is the better metric compared to the net income as it can’t be manipulated that easily and it’s also important for a company to generate cash. You can read more about the benefits of the cash flow over earnings on Investopedia.
Some argue that you should also compare the ratio to the free cash flow as well. The free cash flow tells you how much money is left after the company has spent the money that is needed to maintain and expand its current business. In my opinion, the free cash flow is also a good early indicator of problems that will occur with dividend payments in the next couple of years.
I usually take a look at all of those values and try to calculate them for at least the last 5 years. Sometimes even more. It’s very important that this value shouldn’t grow regularly and shouldn’t be above 75%. If it’s close to 75% and grows in all of the last 5 years it’s quite obvious that it will be above those mark soon.
A good company will mostly make sure to keep this rate low. So again, it shouldn’t be higher than 75% in all of those 5 years! Not just the last one.
Final thoughts and exceptions
Overall, the payout ratio is a great number to see how healthy the dividend payments of a company are. However, there are also some exceptions and limitations of that ratio.
- Even if the payout ratio is below 75%, a company can cut its dividend.
- Some companies stay above 80% but consistently and have a great dividend history (e.g. Realty Income) which can be still great buys.
The first point is very important and there are some companies without a dividend commitment that really cut the dividends even after increasing dividends for several years (Daimler cut its dividend after 7 consecutive dividend increases and its payout is below 50%!). You shouldn’t be trapped by this if you are an income investor. Look for companies with a dividend commitment and also a healthy payout.
Additionally, there are companies that are above 80% payout but stay on that level for decades. Then a higher payout ratio is also not that concerning and even if the earnings drop in one year, they are probably able to increase the dividend by using some of their capital reserves.
The payout ratio is a great starting point. But you need to evaluate the stock a little more than that to really understand what the management is able to do and will do in the next years with your money.