Dividends

Watch Out! A High Payout Ratio Could Get You in Trouble

By Kanwal Sarai
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Investing Payout RatioSmart investors always check the payout ratio, it only takes 5 seconds and it could save you lots of money in the long run. The Payout Ratio is the ratio of money a company gives out to shareholders compared to how much money the company keeps for itself. This ratio is very important because it can be a good indicator of how much you as an investor can expect to receive in the future.

As a shareholder you are part owner of the company. As the owner you are entitled to share in the company’s profits. Your share of profits is called dividends. For example if company ABC is offering $1 a dividend per share per year and you own 100 shares, you will receive $100 every year for as long as you own those shares and as long as the company continues to pay the $1 dividend per share.

If company ABC earned $5 per share and paid out $1 per share in dividends the payout ratio would be: 20%

Payout Ratio = (Dividends per Share) / (Earnings per Share)

Payout Ratio = $1 / $5

Payout Ratio = 0.20

Payout Ratio = 20%

The remaining 80% of earnings is invested back into the company to grow. A 20% Payout Ratio is very healthy, it indicates that the company has room to increase the dividend in the future and is able to grow the business at the same time.

Now imagine a different kind of company, where things aren’t going so well. Company XYZ pays a dividend of $1.50 per share but earns $1.60 per share. What is the Payout Ratio for company XYZ?

Payout Ratio = (Dividends per Share) / (Earnings per Share)

Payout Ratio = $1.50 / $1.60

Payout Ratio = 0.9375

Payout Ratio = 93.75%

A 93.75% payout ratio is very high, this means the company has very little money left over to grow and increase their dividend. 93.75% of what the company earned is paid back to the shareholders as dividends, leaving only 6.25% for the company to reinvest into the business.

A quick search on Yahoo Finance, MSN Money, or any financial website that provides stocks quotes will reveal a number of companies where the Payout Ratio is over 100%.

  • CenturyLink (CTL) 123%
  • Harsco Corp (HSC) 390%
  • HCP Inc (HCP) 158%
  • HNI Corp (HNI) 131%
  • Weingarten Realty (WRI) 2140%

How is a payout ratio over 100% even possible? Easy, the company either borrowed more money or used their savings (cash) to pay the dividend. Do you really want to invest in a company that is not earning enough to pay its shareholders a dividend?

Companies can reduce their payout ratio by increasing either the earnings per share or decreasing the dividend or both.

A high Payout Ratio doesn’t always mean that a particular company is a bad investment. Even good companies will have a bad year now and then, causing the Payout Ratio to skyrocket. But as an investor it is your job to make sure you reduce the amount of risk to your investment. How likely is a company to increase their dividend if the payout ratio is 98%? Not very likely. How likely is the company able to continue paying a dividend if the payout ratio remains over 100%? Not very likely. The Payout Ratio provides a quick test to help you determine the likelihood of continually receiving dividends and especially increasing dividends.

Focus on quality, financially healthy companies where the Payout Ratio is generally less than 75% and you will be on the road to financial success.

Do you own any stocks with a high payout ratio?

Do you own any mutual funds that own stocks with high payout ratios?

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Kanwal Sarai

With more than 27 years of investing experience and a passion for investing and teaching, I demystify the world of investing. My goal is to help you grow your net worth by investing in quality dividend paying stocks. Build your own stream of increasing income today.

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Showing 4 comments
  • The Wealthy Canadian
    Reply

    Hi Kanwal,

    Excellent post; I think a high payout ratio is certainly something for investors to take into account when deciding upon whether or not a particular stock is worth owning. For many cautious investors, I think the range you mention, 75% or less, seems to be a good benchmark range to work with.

    With that being said, I openly admit that I own some stocks that have high payout ratios. As you mention, a high Payout Ratio doesn’t always mean that a particular company is a bad investment.

    To give you an example of a stock I own, let's take Cineplex Inc. (CGX-T). Although the dividend payout ratio for this stock is high (if my calculations are correct, it's currently 137%), there are some key things to this company that cannot be overlooked.

    The company has a virtual monopoly in the segment of the market it is operating in, it has a strong cash flow base, and it a great defensive play. The long-term graph speaks volumes and over the past years in owning it, the company has paid me handsomely both in terms of juicy dividends (currenly at close to 5%) and market appreciation.

    You bring to light an important aspect of analyzing stocks and I think the payout ratio is important for investors to consider when looking at stocks; however, there are some good companies that offer the investor value having high ratios.

    From a personal standpoint, a large percentage of my dividend-paying stocks are large-cap, stable companies that have payout ratios within the reasonable range you recommend. However, I am interested in having a smaller percentage of my portfolio exposed to some stocks having higher risk. As we know, risk and return often go hand in hand.

    Nice post!

    Cheers
    TWC

  • Kanwal Sarai
    Reply

    Hi TWC,

    Thanks for your comments. I like your example for CGX-T, though I haven't researched this company you've piqued my interest! As long as you've got a solid foundation of dividend paying large caps, then you can certainly invest a small portion in "higher" risk stocks. What freaks me out is when people have it the other way around and call it responsible investing.

    Kanwal

  • The Wealthy Canadian
    Reply

    Well said Kanwal.

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