How to Use the Dividend Payout Ratio Metric

While dividend yields capture the attention of bargain shoppers, most serious dividend investors consider a range of other metrics when searching out potentially attractive opportunities. Among these is the dividend payout ratio, an extremely basic calculation that summarizes a company’s use of its available cash. 

Payout Ratio 101

The calculation for the dividend payout ratio is relatively straightforward:

Payout Ratio = Cash Dividends Paid / Net Income

In other words, the payout ratio shows the percentage of a company’s profits that are paid out to shareholders. Management has a number of options for using any cash generated by its operations, including:

1. Investing in machinery, equipment, or other capital expenditures that will increase future revenue;
2. Paying down debt;
3. Paying dividends to shareholders;
4. Repurchasing shares;
5. Purchasing other companies, patents, or brands; and
6. Adding to cash reserves.

The payout ratio reflects a summary of these corporate decisions — specifically the priority given to dividends compared to the other options. As such, it can be useful in evaluating dividend stocks for a couple of reasons:

1. Opportunity for dividend growth. Companies with payout ratios near 100 percent are already distributing most available cash to shareholders. This indicates that in order to grow dividends in the future they will need to increase revenue, lower expenses, or eat into cash reserves. Conversely, companies with low payout ratios typically have some “cushion” to grow their dividend even if revenue and expenses remain stable.
2. Opportunity for revenue growth. Perhaps more importantly, the payout ratio indicates the extent to which companies have other uses of capital. A company that pays out all of its income to shareholders may not have any available projects — such as a new factory or international expansion — that would require an initial cash investment but could increase long-term earnings potential.

There are also a number of limitations to the dividend payout ratio that should be considered as well.

1. Ignores cash pile. There are other factors that can impact the size of the “cushion” a company has that will allow it to increase future dividend payments. Most notably, the size of cash reserves merit consideration here.
2. Buybacks excluded. Dividends represent just one of the ways that companies can create value for shareholders. (For more on the concept of shareholder yield, see this interview with Meb Faber.)
3. Earnings manipulation. The numerator in the payout ratio calculation (dividends) is hard to manipulate, but the same can’t be said for the denominator. Net income (or earnings per share) can be impacted by various non-cash and non-recurring items, which can overstate or understate the total pool of cash available.

Payout Ratio vs. Dividend Yield in Practice

One way that investors can use the payout ratio in stock analysis is consider it in context of dividend yields across all stocks in a sector or industry. Take for example, the following chart that plots the payout ratio against the dividend yield for stocks in the Automotive sub-sector.

While most of these Automotive stocks more or less hug the trend line, there are a few outliers worthy of further analysis:

• Remy International (REMY), Spartan Motors (SPAR), and Superior Industries International (SUP) have payout ratios greater than 100 percent, which should raise a red flag and compel an investor to do further research before buying.
• Ford (F) and General Motors (GM) have dividend yields much higher than the rest of the sub-sector, and though their payout ratios are both above 60 percent, they do sit comfortably below the trend line. This evidence may indicate that these stocks are a good value, though further research into each stock’s fundamentals is advised.

Alternative Ratios

The dividend payout ratio is one of the preferred metrics for evaluating potential investments, as it summarizes a relevant segment of the company’s cash flow using standardized metrics. But for more in-depth analysis, other variations on this calculation may be worthwhile as well.

Dividends / (Cash Flow from Operations – Cash Flow from Investing)

This ratio removes earnings from the equation and instead uses a better indication of the company’s actual cash flow. It also excludes capital expenditures from the denominator, better reflecting the cash available after investments in future revenue streams have been made.

(Dividends + Buybacks) / (Cash Flow from Operations – Cash Flow from Investing)

This slight variation to the formula above includes buybacks as part of the numerator, which results in an indication of the cash used in a broader definition of “yield.”

Dividends / (Dividends + Increase in Cash)

This version of the payout ratio only considers the cash available after all other opportunities — such repayment of debt, buybacks, and capital expenditures — have been considered. This gives a more accurate representation of how companies prioritize cash distributions against building up a base of cash reserves.

The dividend payout ratio is one of the featured metrics in the Dividend Reference stock database because it allows for the comparison of key financial information among companies in a particular sector or industry. But while it is useful for initial screens to identify potential value buys, more customized analysis may be required before making a buy decision.

This article, How to Use the Dividend Payout Ratio Metric, first appeared on Dividend Reference.