What is a payout ratio?
A payout ratio is a very common metric in dividend investing. Simply put, it is the proportion of earnings that are paid out as dividends to the shareholders. Most investing sites will supply you with this information but I always like to recommend that an investor determine the payout ratio themselves during their research stage.
What is the formula for payout ratio?
Payout Ratio = Total Dividends / Net Income
You can find the total dividends listed on the statement of cash flow for the company. You will be able to find the net income on the income statement. I would recommend to not only look at these numbers from a quarterly perspective but to also look at them annually as well.
What can I learn from the payout ratio?
The most important thing that you can learn from this financial metric is if the company is able to cover the payment of their dividend with income alone. You may be asking your self why this would be important. Quite simply, if the company is not generating enough income to cover the dividend then they are forced to either use the cash that they have on hand, which is a finite amount and would run out eventually if they had to keep using it, or they would have to take on debt to cover the dividend.
A current example of this scenario would be in the oil and gas sector. Because the price of crude oil has been depressed for such an extended amount of time some oil companies have began taking on more debt just so that they can cover their dividend. Since interest rates are still very low compared to historical averages, this is not necessarily a bad plan in the short term. The problems will arise if the price of oil continues to stay depressed because the company can only sustain so much debt even at cheap prices.
In this scenario, by knowing the payout ratio of the company it allows you to be understand what the future of the company may entail and if it is a good time to invest in stock of that company.
What is a good payout ratio?
A good payout ratio is going to be very subjective depending on which investor that you ask. I do generally agree with most investors that I would like to see a payout ratio between 60% and 80%. Obviously, I would like to see it down closer to the 60% because that means it will be easier for them to grow their dividend over time or that they would even be able to take a hit on their net income and would still be able to cover their dividend.
Here is the part where it may get real debatable. While I would like to see the company paying out around 60% to 80% there are circumstances where I would be ok with the company paying out a smaller percentage of their earnings as dividends.
For instance, if the company is only paying out 30% as dividends but they are heavily investing in projects that will create growth for the company. As a long term investor if they are creating that growth within the company than I will still be able to reap the benefits of it over the long term.
One might argue that they would rather receive the dividends but in my opinion what good would the dividends do if they are not able to continue growing them over the long term. While I love receiving dividends as much as the next investor, I do believe that there are other ways that a company can return value to shareholders and investing in their business to grow earnings is one of them ways.
While I do support this scenario, it would definitely be case by case rather I felt that the company was investing their money wisely which would warrant the smaller payout ratio.
Why do REITs have such large payout ratios?
This is where it is very important as an investor for you to do your own research and analysis. Most of the stock information websites that I see show a rather large payout ratio for real estate investment trusts. It is so large in fact that it would appear that the company would not be able to sustain their dividend.
This is normally not the case at all. What is happening is just a little bit of accounting trickery. As you will recall from earlier, the formula that I gave you was payout ratio = total dividends / net income. That formula works great for a regular business but not so well for a REIT.
Let me explain why that is. Because REITs are invested in real estate when they do their books through GAAP standards they are able to depreciate the value of the properties in which they own. Now the problem is that by depreciating the value of the properties they are actually manipulating their net income that they will report on their cash flow statement. They are not actually doing nothing nefarious that is just the way that the GAAP standard is designed.
Since our standard payout ratio is distorted there is a better way for us to analyze the payout ratio of a REIT.
Funds From Operations or FFO is that better way. This metrics gives us a truer picture of the real income that the REIT is earning from their operations. The formula for FFO looks like this:
FFO = Net Income + Depreciation + Amortization – Gains on Sales of Property
So we see here that it is the net income added with depreciation and amortization minus the gains on sales of property. That may seem a bit complex. In simpler words, it is the money that they earn from the rent on their properties.
So if we relate this to our payout ratio formula, it would look more like this:
FFO Payout Ratio = Total Dividends / Funds From Operations
Using this formula, we can now analyze the payout ratio of real estate investment trust.
All About Payout Ratios!!!
It is never a good idea to make investment decisions based on one metric so I would recommend that the payout ratio only being one part of your analysis. For instance, another common metric would be Earnings Per Share or EPS. You may also decide to look at the companies dividend growth history. All of these are great metrics that I look at before I invest in a company. What are some other metrics that you look at?
Despite all that we have covered about payout ratios there are still accounting tricks that can be used to manipulate the numbers that companies report but now we are prepared to decipher the numbers that we are given. Having these new abilities to determine a companies payout ratio will benefit any investor as they prepare to research and analyze a companies financial reports.
Hopefully, now you feel more prepared to decipher a companies payout ratio.
As always I look forward to reading all of your comments and questions, until then….. happy investing!
-Jason from MoreDividends.com
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