There are several criteria to evaluate when buying stocks. Most fall into one of three categories: safety, growth and yield. From yield-chasers to dividend growth investors, regardless what type of income investor you are, most retail investors don’t spend enough time analyzing the safety of the dividend.
It doesn’t matter if you want your income to grow (or not), most will agree on one thing – it must be reliable. Unfortunately, not enough time is spent in this area.
Don’t get tunnel vision with dividend payout ratios
One of the biggest mistakes retail investors make is to look at the dividend payout ratio as a measure of the dividend’s safety. The payout ratio is one of the most relied upon, and misleading metrics. In its most common form, the payout ratio is defined as being the percentage of earnings paid out in dividends.
Too often, investors will make rash decisions based on this payout ratio alone. If a company has a payout ratio over 100%, they conclude the dividend is not sustainable. Similarly, if it comes in at 50% then they surmise that the dividend is well covered.
Are these conclusions accurate? Maybe, maybe not.
Without investigating further, it is impossible to know. Earnings contain many non-cash items and one-time expenses that have no bearing on a company’s ability to pay a dividend.
It is for this reason, there are many companies who have long and storied streaks of dividend growth with payouts above 100%. It is also why companies who appear to have low payout ratios cut their dividends.
The payout ratio is still important, just not as important as you think
I am not saying that the dividend payout ratio is not a valuable metric. It is however, only one of several metrics’ investors should consider when buying or selling stocks.
As an example, a company that has a reliable dividend growth streak, or one that has never cut/suspended its dividend has shown a certain level of commitment to investors. This is an important factor to consider.
Does the company have a dividend policy? Some companies have targeted payout ratios, that can help investors determine if an impending cut is on the horizon.
Then there are payout ratios as a percentage of cash flows. These are some of the most important ratios to analyze. At the end of the day, dividends are paid out in cash and if a company does not have enough cash, it will have to borrow to sustain the dividend. This never ends well.
In some cases, companies spell out what that means – from adjusted funds from operations to distributable cash flows.
Most won’t make any reference to the payout ratio as a percentage of cash flows, and you will have to do your own due diligence. The two most common ratios are dividends as a percentage of operational cash flow and free cash flow.
The key is to not stop at the payout ratio. Analyze all these together, and you may be surprised that your initial thoughts on the safety of the company’s dividend may have been un-informed.