Everybody worries about making bad investing mistakes. You don't want to lose your hard earned money, so it's important to make sure you are making the right decisions. One metric I always look at is the Payout Ratio, it only takes 10 seconds to check and can save you thousands of dollars in making poor investing decisions.
What's a Dividend?
But first, what is a dividend? A dividend is a cash payment paid to shareholders. The company decides when and how much to pay shareholders. As a shareholder you are part owner of the company, essentially the company is sharing its profits with you the owner. You can spend your dividends or re-invest them if you like.
Earning for Life
For example, if company XYZ has an annual dividend of $1 per share, and you own 1000 shares you will receive $1000 cash each year for as long as you own those shares, and as long as the company continues to payout the $1/share dividend. You will continue to receive $1000 cash per year regardless of the share price, the stock price can drop or increase but the dividend will remain, as long as the company maintains its dividend.
But Dividends Are Not Guaranteed
Companies are under no obligation to pay dividends. Companies can reduce or eliminate the dividend at any time. Then how do you know you'll get paid a dividend?
Watch the Payout Ratio
Here's a quick look at two companies to help explain the Payout Ratio:
Annual Dividend per share: $2
Annual Earnings per share (EPS): $5
Payout Ratio = Dividend / Earnings = $2 / $5 = 0.40 shown as a percentage is 40%
Annual Dividend per share: $2
Annual Earnings per share (EPS): $1.50
Payout Ratio = Dividend / Earnings = $2 / $1.50 = 1.33 shown as a percentage is 133%
Which is the better Company?
Looking at both examples above, you can see that Company A has a healthy payout ratio of 40%. Company A earned $5/share and only paid out $2/share in dividends to it's shareholders, the rest of the money the company kept to grow it's business. Just 40% of earnings was paid out to shareholders, which leaves room for future increases in dividends, and gives the company more money to grow their business.
Company B earned $1.50/share but paid out $2/share to shareholders. The payout ratio of 133% is very high, there is no room for the company to increase it's dividend let alone continue to pay the current dividend. There's three possible options for Company B:
All things considered equal, Company A is going to be a better investment. Investing in Company B would be putting your hard-earned money at risk.
A Friend is Recommending a Stock to You?
Next time someone recommends a stock, have a quick look at the Payout Ratio, and if it's over 100% don't bother investigating further. Thank your friend for the "suggestion" and move on with the rest of your day.
Actual Payout Ratios
Let's take a look at some current (as of this writing) Payout Ratio numbers:
Barnes & Noble (BKS)
Annual Dividend per share: $0.60
Annual Earnings per share (EPS): $0.02
Payout Ratio = Dividend / Earnings = $0.60 / $0.02 = 30 shown as a percentage is 3000%
Cogent Communications Holdings (CCOI)
Annual Dividend per share: $2.32
Annual Earnings per share (EPS): $0.63
Payout Ratio = Dividend / Earnings = $2.32 / $0.63 = 3.68 shown as a percentage is 368%
Annual Dividend per share: $3.71
Annual Earnings per share (EPS): $8.78
Payout Ratio = Dividend / Earnings = $3.71 / $8.78 = 0.42 shown as a percentage is 42%
Which company has a healthy payout ratio? You are right if you guessed Pepsi. Does this mean you should invest in Pepsi today?....not so quick, keep reading...
Payout Ratio and More
Dividends are not guaranteed and, no one can tell the future, no analyst or expert can predict if a company will continue to pay dividends in the future. However, the Payout Ratio gives you insight on whether or not a company can afford to pay you the shareholder. Looking at the Payout Ratio is one of 12 Rules that I follow to help me select the best companies to invest in, you can do the same for yourself.
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