Watch Out! A High Payout Ratio Could Get You in Trouble
Smart 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? Did you enjoy reading this article? If so, I encourage you to sign up for my newsletter and have these articles delivered via e-mail once a month…and it’s free!