Dividend Payout Ratio [3 Risks You Can’t Ignore] (2024)

Understanding the dividend payout ratio and biggest dividend risks will help put cash in your pocket.

There are three major risks to a stock’s dividend payout ratio that WILL mean the difference between solid returns or big losses.

Ignore these risks or just hope they don't hit your portfolio and you could lose thousands of dollars. Understand the risks and learn how to avoid them and you'll watch your portfolio spin off cash in dividends every month.

In this video, I’ll not only explain the dividend payout ratio, I’ll reveal those three payout ratio traps and how you can be a better investor.

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What Investors Don't Know about the Payout Ratio

We’re in the middle of a series of videos on dividends and anyone in the community knows I’m a huge fan of these cash flow stocks. Research upon research has shown that dividend stocks tend to do better than other investments.

Probably the most famous, we see here research by the Ned Davis firm that over nearly four decades, dividend stocks returned an annual rate of 7.2 to 9.5% compared to a return of just 1.6% on stocks that didn’t pay a dividend.

But one of the most important concepts individend investing isn’t well known by most investors. This metric goes to thevery heart of a company’s dividend payment and its ability to keep paying oreven grow that dividend. Ignore this measure and the risks we’ll talk about andjust wait for that stock to collapse because it will happen if you don’t knowwhat to watch for.

We’re talking about the dividend payout ratioand this is simple the percentage of the company’s profits it pays out as adividend. I’ll show you two ways to calculate the payout ratio in a moment butbasically it’s just the dividend divided by a company’s earnings, it’s netincome.

What is the Dividend Payout Ratio?

Now if we look at the two sides to the payout ratio, you’ll see just how important it is and maybe even start to see some of the risks we’ll talk about. Dividends paid by a company are a big responsibility, it’s a commitment not only to make a current payment but most investors see it as a commitment to make future payments as well.

All you need to do is look at any company that’s cut its dividend payment and watch the stock price to know how important that forward planning for cash flow is for a company.

On the other side of the dividend payoutcalculation is just as important, the company’s earnings. Stocks are anownership on those earnings so this is directly related to a stock’s value andit’s price.

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How to Calculate the Dividend Payout Ratio

The payout ratio is super easy to calculateand a couple different ways you can do it. Some websites or even the company’sfinancial statements may tell you the dividend payout ratio but it’s so easy tocalculate on your own, I like to double-check the numbers anyway.

The first way to find the payout ratio is just to go to a company’s financial statements, so here we are on the Apple stock page on Yahoo Finance and we’ll click on Financials in the menu. This will take us to the three financial statements.

The income statement shows the sales and profits of the company over either a year or three months. The balance sheet shows us the company’s assets and debts at a point in time and the cash flow statement shows us the actual cash in and out of the company over a year or three months.

These three statements are something we’vetalked about on the channel and you know I’m a big believer in using thisStatement of Cash Flows rather than the income statement. Most investors getcaught up in those sales and earnings on the income statement but these are allmanipulated by management to make the company look as profitable as possible.It’s much harder to bias those cash flow numbers because it’s actual cashaccounting and in fact, this is where professional analysts spend most of theirtime, looking at those cash flows.

Anyway, so we’ll first click over to the cashflow statement and make sure it’s set on annual here. Then we’ll come down hereto Dividends Paid, so this is the annual amount Apple paid out as dividends inthis year and this number we see is in billions of dollars. So the company paidout $11,561,000,000 in dividends this last fiscal year.

Now we’ll scroll back up and click over to theincome statement which will show us the net earnings for that year. Here we’lllook for this Net Income from Continuing Operations or Net Income Available toShareholders and we see it was $53,394,000,000 for the year.

So we’ll open our calculator and if we takeour eleven billion in dividends paid and divide by the fifty-three billion andchange in net income for the same period, we get a dividend payout ratio ofabout 22% for Apple during that year. Now this payout ratio is going tofluctuate a few percent from year to year so you should really take an averageover a few years but either way gives you a good idea for comparison.

Another way to find the dividend payout ratio, and it really makes no difference which way you use, is to do it on a per share basis. So here we’re on the Apple stock page again and we see that Apple pays $2.92 a year per share in dividends.

Understand this is a forward dividend so the current quarterly dividend times four. Now we need the per share net income or earnings so we scroll down to this Earnings graphic and we see each of the last four quarters. We can use this method anywhere you find per share dividends and earnings so not just Yahoo but the site makes it really easy.

First we’ll add up each of these quarters’ earnings to get the full year number and we get earnings per share of $12.16 over the last year for Apple. Then we just take that $2.92 in dividends and divide by the earnings for a dividend payout ratio of 24%.

Understand this is going to be slightly different than the other method because you’re using the current dividend times four so dividends over the next four quarters and using the last four quarters in earnings. Technically, you should find the last four quarters in dividends but this will give us an estimate that’s as close as we need for comparisons.

Dividend Investing Risks

Now that we have the payout ratio for a stock, I want to reveal three risks to looking at this you can’t ignore. These three ideas are going to be critical to using the dividend payout ratio and picking the best stocks.

The first risk you want to watch for in thepayout ratio is a company paying out too much of its earnings as a dividend. Iknow we all love dividends and it’s great seeing that high yield but there’s atradeoff you need to watch. A company paying out most of its profits as adividend isn’t going to have much left to grow the business, to grow those earnings.

Now we know that the share price of a companyis based on those future earnings, that’s what you’re investing in is a shareof those profits. If earnings aren’t going to be increasing or worse yet mightdecrease because the company hasn’t spent enough to stay competitive, then thatstock price could suffer. Obviously, it does no good to collect a juicy 10%dividend yield on a stock if the share price falls by 15% during the year orover a period.

Of course the question becomes, how much of earnings can a company pay out before it starts limiting growth? For this you can start by just comparing it to the dividend payout ratio for other companies in its industry.

Remember, and this is extremely important in a lot of investing ideas, you always want to compare a company with others in its industry, not just with all other stocks or other companies outside the industry.

Here we see a few industries and their payoutratio. This is data collected by Professor Damadaron of the Stern School atNYU, a great resource for investors and you can see how much some of theindustries differ on their payout ratio. You’ve got household products andutility companies that pay out the majority of their earnings some even morethan their earnings as dividends. Then you’ve got the biotech drug industrythat almost pays no dividends at all.

Think about this from a management perspective. The growth prospects are more limited in older industries like household products or in regulated ones like utilities. Debt is very easy to come by for these industries with stable cash flows so they can pay out lots of dividends and borrow if they need more money.

On the other hand, industries like biotech and semiconductors, it’s all about reinvesting in research and development to create new products. Debt is more expensive because sales and profits are more volatile so these companies need to keep more of their cash back instead of paying it out as dividends.

This is why you absolutely must compare companies with others in their industry. This goes for not only comparing the dividend payout ratio but other metrics like price-to-earnings, dividend yield, and sales growth as well.

Comparing a payout ratio with the industryaverage, you start to do some analysis. If they’re paying out more, is it goingto be at the expense of growth. If they’re paying out less, does that mean thecompany will grow faster or is it an opportunity to increase the dividend? Youcan also compare a company’s payout ratio with it’s own history, so going backto look at how the payout ratio has changed and how that has affected salesgrowth.

The second place you need to look when you’re looking at dividend stocks and payout ratios is whether the payment is supported by cash flows.

Dividend payments and a share buyback program can be a big drain on cash and can turn into a problem if that cash flow evaporates. In fact, this is what happened to Warren Buffett in his IBM investment, one of the worst investments he’s ever made. Buffett started buying shares in IBM in 2011 seeing a cheaper share price and chasing that high dividend yield. The company also had a huge share buyback program that was boosting its earnings per share.

The problem was, and for this we look at the Statement of Cash Flows again, it was paying for all this with lots of debt. If you go down to where it says Common Stock repurchased and Dividends paid on the cash flow statement, we see that IBM was burning through about $18 billion in cash through the dividend and buyback each year.

Now you look a little further down to where it says Free Cash Flow. This is the cash generated by the business that Operating Cash Flow and minus capital expenditures which is cash invested in equipment and other things to keep the company running. So this Free Cash Flow is a measure of how much cash is left over after reinvesting enough to keep the company stable and you see that it was well under that $18 billion for all five of these years.

So IBM was spending all this cash buying back its own shares and paying out a dividend and it was paying for it by just piling on the debt. If you look at the difference between the debt issued and the debt repayment, the company borrowed more than $24 billion over those five years to pay for all this.

This is something that obviously couldn’t go on forever. The company’s sales weren’t rising fast enough, interest payments were ballooning and the stock price tumbled from a high of about $215 a share in early 2013 to $150 per share towards the end of 2017 when Buffett finally gave up on the investment.

This is something you have to watch,especially in those dividend stocks with a high payout ratio. You need to checkback each year into that Statement of Cash Flows, look at how much cash thecompany is paying out in dividends and share buybacks. Then look at where thatmoney is coming from. Is it coming from cash generated by the business, thatCash Flow from Continuing Operations, or is it coming from new debt? Is thecompany still spending as much as it has in the past on capital expenditures,that money reinvested to keep the company competitive and grow it, or is itcutting back in order to meet those cash payouts?

Dividend Investing in REITs and MLPs

Our third risk to remember when you’re looking at the dividend payout ratio is you can’t apply this to real estate investment trusts, REITs, or to master limited partnerships, MLPs.

We talked about this in a prior video on thesetwo special types of companies. REITs hold and manage real estate and then payout the majority of cash flow to investors. MLPs hold energy assets likepipelines and storage facilities. Both get a special tax break by paying outmost of the annual income as dividends so these are some of the best dividendyielding stocks you can find with a yield three-times the market average.

The problem is that these two types of companies have so much in depreciation expense, that’s the accounting trick they get to use on the income statement. They have these properties or pipelines and get to take a certain amount off the value each year to deduct it from their earnings.

That makes their earnings, that net income look artificially low because the deduction isn’t actually cash going out the door. So if you take the dividend payment divided by this artificially lower net income for these types of companies, you get a payout ratio of over 100%, making it look like they’re paying out more than they have and in danger.

With MLPs and REITs, you have special earnings measures you use instead of that net income. For REITs, you use what’s called the funds from operations or FFO. For MLPs, you use what’s called the distributable cash flow or DCF. I’ll show you how to find both of these next but they’re always available on a company’s annual report as well so you don’t necessarily have to calculate them.

Just like with using net income when wecalculate the dividend payout ratio, you use these two measures, the FFO forREITs and the DCF for MLPs, to find how much of the company’s core earningsit’s paying out as dividends. You can then compare that to similar companiesand to the company’s own history to analyze if it’s maybe paying too much orcould increase the payout.

While sustainable DCF is a better measure, mostpeople use the DCF as reported because it’s sometimes the only number reported.To get to DCF, you also add back that income from non-controlling interests aswell as working capital reported. The big one here is adding back this proceedsfrom asset sales. This is technically proceeds the company can return toinvestors, a company can’t forever be selling its assets and still keepbusiness running so that’s why we use that sustainable DCF if it’s available.

For real estate trusts, FFO is very similar tothat DCF we saw with MLPs. You take the reported net income of the REIT and addback depreciation but minus out any gains they made on property sales. Thoseproperty sales are a source of income but not something the REIT can do foreverand expect to stay in business.

Investors also look at the adjusted funds fromoperations this AFFO, which takes out capital expenditures. Capex here is moneythe company spends to keep its properties in good shape so maintenancespending. Remember, the idea is to find how much cash the company has availableto distribute without cutting into money it needs to run the business.

We’re about half way through out 2019 Dividend Stock Challenge portfolio and the stocks are blowing up. The portfolio is up over 24% so far and beating the market by nearly ten percent. Check out the portfolio and don't forget to always be watching for those dividend payout ratio risks and warning signs in your stocks.