What is Payout Ratio? Should you use it?
When you get into DIVIDEND INVESTING, you’ll run across a term called PAYOUT RATIO. To properly evaluate a companies ability to continue paying its
Visualize a pie. If the company gives you 25% of the pie, that leaves them with 75%. They can use this 75% to grow a bigger pie so to speak. Suppose a company gives you 98% of the pie, well that now only leaves them with 2% of earnings to continue growing the company. The higher the percentage of the pie they are paying you, the less they are keeping, the less they can increase the Dividend and the less ability they have to grow it as well.
This is why seeking high-yield investments can often be a bad decision. If it’s paying you 8% but you are getting 98% of the pie, then that company probably doesn’t know what to do with the extra cash. Most importantly, they have reached the ceiling for dividend growth.
Believe it or not, there are companies that are paying out more than they are bringing in, often easily spotted by payout ratios above 100%. It doesn’t take a rocket scientist to know that’s not sustainable. It’s worse than a negative pie, having nothing to eat.
I have found companies whose ability to pay the dividend depended on them selling equipment. What happens when they run out of stuff to sell off? This is why learning how to read a balance sheet is important as well.
How do you calculate this PAYOUT RATIO? The easiest way is as follows:
(Dividends Paid out to Shareholders/ Net Income ) * 100
Are there any problems with using this metric?
It turns out there is. A company can use accounting tricks to hide things with earnings and it’s net income that doesn’t tell you the entire story. In addition, dividends are paid out of CASH FLOW, not earnings. It is CASH FLOW that’s most important when it comes to dividends and the ability to grow it. For that reason, I will discuss how to calculate the CASH FLOW PAYOUT RATIO in another blog.
I often look at both the PAYOUT RATIO and the CASH FLOW PAYOUT RATIO, comparing them, looking for any discrepancies.
REIT’s are a whole other ballgame that are even more complicated. Payout ratios tend to be near 100% or over for a REIT. This is due to the Deappreciation that REIT’s are required to do, it messes up the calculation.
For REIT’s, one usually uses what is called FFO (Funds From Operation). I will go into detail how to calculate that in a later blog as well. For now, just understand, if a REIT has a payout ratio of 100% or more, don’t freak out immediately. There is more going on.