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Education: Growth & Income Investing

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When growth and income investors start hunting for stocks with high dividend yields, this individual should make it a point to check out a company's payout ratio as well. While it may not be a very sexy ratio, it deserves a quick peek.

Payout Ratio Defined

A company’s payout ratio can be defined as the proportion of its earnings paid out to common stockholders in the form of cash dividends. More specifically, the number is calculated as follows:

Payout Ratio = Dividends per Share/Earnings per Share

As we always do, let’s go over a quick example. If Simon, Bennett, Robbins, Oppenheim & Taft, Inc. paid out $1.25 per share in annual dividends and its earnings per share amounted to $2.75, the company’s payout ratio would be 45%. Okay, so what does this tell an investor interested in possibly purchasing stock in this particular company? Is this an attractive payout ratio?

Interpretation

I think it is pretty clear that the payout ratio can provide a window into what a particular company is choosing to do with its profits. A company sporting a very low payout ratio is one primarily focused on investing their earnings back into the company versus sharing them with their shareholders. On the other hand, a rather large payout ratio most likely means that reinvested earnings would return less than what shareholders could get investing the payout on their own. Thus, the decision is made to share the wealth with stockholders.

However, abnormally large payout ratios over a long time period could signal a red flag for investors. Companies that fall into this category may have to cut their dividends in order to tap into earnings for internal growth purposes. Investors have come to expect this additional form of income, and if reduced, the stock’s price can suffer as a result.

There are no clear cut parameters for what is defined as a dangerously large payout ratio. It is recommended that a company’s payout ratio be compared to other companies participating in the same industry. While large payout ratios are common in some industries (utilities for example), they may not exist in others.

Furthermore, and of most importance, faltering earnings can lead to an artificially high payout ratio. By looking at the formula above, you will notice that dividends per share are divided by earnings per share. Let’s go back to our earlier example in which Simon, Bennett, Robbins, Oppenheim & Taft, Inc. paid out $1.25 per share in annual dividends with earnings per share of $2.75, leading to a payout ratio of 45%. If the company maintains its current dividend policy, but its earnings per share fall to $2.15, its payout ratio would now be 58%--a jump of 13%!

Conclusion

If you are an avid reader of our educational articles, you know by now that one should never evaluate a company on one metric alone—that is, unless we are talking about the Zacks Rank. When growth and income investors are looking at a company’s dividend yield, return on equity, payout ratio, etc., it is highly recommended that one also check out its Zacks Rank. What is the most tangible proof that a company can maintain its dividend policy and is worth holding for the long term? Earnings and earnings growth. With earnings estimate revisions serving as the backbone of the Zacks Rank, you can see how this calculation can be extremely valuable (Learn more about the Zacks Rank).

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