As regular readers know, every month we post the top dividend stocks from the S&P500. Then, a few days later we send out a newsletter (you can sign up for it free) which takes a deeper look into those stocks in order to get not the highest dividend stock but the one that shows the most promise in terms of long term passive income. That generally implies a healthy company (financially) that is growing its dividend and can afford it. One of the criterias that we also use is the payout ratio which we decided to spend more time looking into today.
What is a payout ratio?
The payout ratio is a fairly simple concept, it represents the portion of earnings that is paid out to shareholders. The calculation is quite simply:
Payout Ratio = Dividend per share / Earnings per share
For example, a company that makes a profit of 2$ per share every year and pays out 1$ of dividends would have a 50% payout ratio.
Why you would want a low ratio
Conventional wisdom implies that you would look for a company with a very low payout ratio. Why? Because as you can imagine, a company that has a high payout ratio could very well be unable to continue offering its high dividends. It is non sustainable for a company to pay more out through dividends than what it actually generates. When that happens there are 2 options. Either diminish the dividend or increase earnings, both of which are challenging.
Because of that we have used the payout ratio in a very simple manner in our search for the top dividend stocks; setting a maximum “acceptable” payout ratio that we apply to take out non qualifying stocks.
Why you actually might want a high ratio
All of that being said, there are corporate finance theories that suggest you might not want to have a very low ratio either. One of the advantages of a high ratio is that its puts more pressure on managers to increase their earnings in order to be able to pay and increase the dividends. Such pressure has often been proved to generate better results in the end. It is psychological but it tends to help managers focus on increasing earnings and dividends.
Think about it for a second.. Do you tend to spend more when you have 10,000$ in your bank account (whenever that happens) or when you have a couple hundred dollars? Chances are that when you go shopping, you are much more inclined to spend with a big balance in your account. It is the same thing with companies that are only accumulating big cash piles. They often are less careful with spending which in the end hurts shareholders. A lot of research has been done over the years to prove this theory.
Another reason would be that a company that pays out most of its earnings will be able to make you profit a lot more when they increase those profits. A 50% increase in profits over the years could very well mean a 30-40% dividend increase as well if the ratio is maintained.
It is all about a balance
Like everything else, it is not black or white. You surely do not want a company that is unable to sustain its dividend payout and payout growth but you also want to look for a company that can be as efficient as possible. I will be trying out a few different numbers in the next few months to see what kind of results it generates. Be sure to sign up for our weekly newsletter if you want to find out more.
These stocks, all solid, consistent dividend payers all pay between 50% and 75% of their earnings out in dividends:
Pitner Bowes Inc (PBI)
Bemis Co Inc (BMS)
Eli Lilly (LLY)
There are many others…
So which do you prefer?
Would you be looking for a stock that pays a tiny portion out of their revenues or a larger chunk?