Tuesday, October 25, 2011

Boring Terms We Need To Know: Dividend Payout Ratio

The second term in our "Boring Terms We Need to Know" series is dividend payout ratio. Dividend payout ratio is an important statistic that we need to be aware of and use when analyzing a dividend stock.  If you found Yield on Cost to be fairly easy to grasp, then you'll have no problems understanding dividend payout ratio.

Dividend payout ratio is simply the percentage of a company's earnings that is paid out to its investors in the form of dividends.  The ratio is easy to find on Yahoo Finance.  Just go to the a stock's quote page, click on "Key Statistics" link and search for "Payout Ratio".  Here is an easy example if you want to figure out the ratio on your own.

Company XYZ had $500,000 net income this year.  It paid out $100,000 in dividends to shareholders.  Company XYZ has a dividend payout ratio of 20% (100,000 / 500,000).  Pretty simple right?  So as we analyze a stock what exactly are we looking for when examining its dividend payout ratio?

  • A low payout ratio - A low payout ratio means the company has plenty of room to grow their dividend payment.  Typically I like to see a payout ratio < 50%, but this is dependent on the type of business the stock is in. Coca Cola doesn't need to retain as much of their earnings to reinvest in its business than IBM, who operates in an ever-changing technology sector.
  • A steady or decreasing payout ratio over time - If a stocks payout ratio has been increasing over time this means that the dividend increases have been outpacing earnings increases.  This can be a sign that future dividend increases will be smaller so they don't eat into a company's earnings.  Its best to see a steady payout ratio (dividend increases are the same as earnings increases) or a decreasing payout ratio (earnings increases are higher than dividend increases).  One way to figure this is to ensure that the current payout ratio (or 1 Year payout ratio) is less than or equal to the average 5 year payout ratio

Here are 4 stocks that are paying out less than 50% of their earnings in dividends and the current payout ratio is less than or equal to its average 5 year payout ratio.
  1. Exxon Mobile (XOM- XOM engages in the exploration and production of crude oil and natural gas, manufacturing of petroleum products, as well as transportation and sale of crude oil, natural gas, and petroleum products.
  2. Current Payout Ratio: 24%     5 Year Average Payout Ratio: 26%
  3. Archer-Daniels-Midland (ADM) - ADM procures, transports, stores, processes, and merchandises agricultural commodities and products in the United States and internationally.
    Current Payout Ratio: 20%     5 Year Average Payout Ratio: 20%
  4. Coca-Cola Company (KO) - KO manufactures, distributes, and markets nonalcoholic beverages worldwide
    Current Payout Ratio: 34%     5 Year Average Payout Ratio: 48%
  5. Wal-Mart Stores Inc. (WMT) - WMT operates retail stores in various formats worldwide.
    Current Payout Ratio: 28%     5 Year Average Payout Ratio: 28%
In a future post in this series I will discuss free cash flow payout ratio.  This ratio is similar to the above earnings payout ratio, but can be a better guide than earnings as the earnings figure can be manipulated by today's corporate accountants.  I hope to shed more light on cash flow vs earnings before tackling free cash flow payout.  We'll deal with all of that another day.

Disclosure: I am long WMT.

Related Posts:  Boring Terms We Need To Know: Yield on Cost

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