What Dividend Investors Need to Know About Payout Ratios

From the Mailbag:

G’day Guys,

Could Marc or the Wealthy Retirement team explain what payout ratios are and why he likes to use free cash flow to evaluate dividend safety?

Also, would you automatically sell a stock if its payout ratio went over 100%?

In the dividend world, the payout ratio is the amount of money a company pays out to shareholders in the form of dividends divided by the money the company made.

[ad#Google Adsense 336×280-IA]It’s a fairly simple math equation that gives you a percentage.

However, determining what to use as the denominator, the money the company brought in, is where it can get tricky.

Most analysts follow earnings or earnings per share.

That’s why you often see dividends listed underneath earnings per share on financial summary Web pages.

To calculate the earnings-based dividend payout ratio, divide dividends paid by earnings.

It’s a readily available number, but we don’t use it.

Earnings don’t tell the whole story when it comes to dividends. Keep in mind that dividends are paid with cash, not earnings. Earnings are not the same as cash flow. And, as Marc often points out, earnings can be manipulated. They include a lot of noncash items such as depreciation, stock-based compensation, amortization and other expenses, which can be bumped up or down at management’s discretion.

That’s why Marc’s Safety Net formula uses a payout ratio based on free cash flow to help determine dividend safety.

Free cash flow is the amount of cash a company generates from its business operations minus the money it spends on capital expenditures. To find it, just divide the amount of money a company pays out in dividends each year by the amount of cash it brings in the door: free cash flow. You can find the information on the company’s statement of cash flows.

Dividends Paid / Free Cash Flow = Payout Ratio

To Marc, the payout ratio based on free cash flow is the most important metric to use when evaluating dividend safety. That’s because the lower the payout ratio, the more room a company has to raise its dividend without tapping into the cash on its balance sheet.

And if business hits a bump in the road and cash flows fall, the low payout ratio provides investors with a margin of safety that the company will continue to pay its dividend.

Marc prefers payout ratios under 75%, excluding master limited partnerships and real estate investment trusts.

But the payout ratio is not the only metric we have to use when determining the sustainability of a dividend. It’s not the end-all, be-all in the dividend safety world. And I’d never automatically sell a stock if its payout ratio trickled over 100%, or worse, became negative.

Don’t get me wrong, an oversized or negative payout ratio definitely throws up a yellow flag as to whether the dividend stream will continue.

But it does not always mean the dividend will be cut. That’s because if a company has enough cash on the balance sheet and a long dividend-paying history, it is often willing and able to continue to pay the dividend. Investors expect it and company management knows that. Just remember: A jumbo payout ratio cannot go on forever.

Management will often cut spending to increase cash flow so it can maintain and sometimes even raise dividends. If it’s a short-term problem, the company will right itself and cash flows will rise to cover the dividend. This is why many companies are able to continue paying uninterrupted dividends despite their free cash flow shortfalls.

Consider Exxon Mobil (NYSE: XOM) during the last oil crash in 2009. Exxon generated $5.95 billion in free cash flow and paid out $8.02 billion in dividends to investors. The payout ratio was 135% and the company had to dig into its cash on hand to cover the dividend.

Fast-forward to 2010. Oil prices rebounded and Exxon’s free cash flow increased 262% to $21.54 billion. That year, it paid out $8.5 billion in dividends, bringing the company’s payout ratio down to a very comfortable 39.46%. If investors sold the stock just because its payout ratio had creeped above 100%, they would have missed out on a lot of dividends.

Besides the payout ratio, the company’s dividend payment track record and projected free cash flow growth are also important. In the short term, the amount of cash and debt on the balance sheet as well as the company’s ability to cut expenses often sustains the dividend.

As long as the free cash flow fall is temporary and not the new normal, dividend investors can ride out the wave. However, they should keep a watchful eye on the payout ratio and free cash flow projections. If the tide continues to turn, they may want to abandon ship.

Good investing,

Kristin

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Source: Wealthy Retirement