Friday, July 29, 2011

Dividend Payout Ratios

Most important question to ask on dividend paying stock: “Can the level of dividends be sustained?” Also, once you have a company, you need to focus also on its ability to pay their dividend rather than on the stock price. I have found that the value of my portfolio has fluctuated a lot, but my dividend income has not. In fact, my dividend income has only increased since I held a basket of dividend paying stock.

If you just concentrate on your portfolio value, it might drive you crazy and you might just sell when you should not. I have found that in recession, some companies cut or eliminate dividends, some keep them level and other increase them. Overall, my dividend income has still increased. So, what you should be looking at is cash flow. When you look at dividend cash flow, you have to look at it over a 3 month period to get Cycle 1 to 3 of dividend payments. Or, you can look at dividend cash flow over a 12 month period.

Of course, when a company I own cuts or eliminates dividends, I check on the long term viability of the company. You have to ask yourself if you should buy more, sell some or all or just hold on a stock on such a company.

I look at Dividend Payout Ratios based on earnings and on cash flow. If I see some problems I might investigate the company further. I know that some analysts look at DPR based on Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO) and Free Cash Flow.

I look at such things sometimes on a short term basis and for REITS, but I do not like to do this on a long term basis for a company. When a company cannot provide a positive EPS higher than the dividend over the long term, it suggests to me that the company is mortgaged to the hilt and not a good long term buy. You should be aware that there are many analysts that seem to disagree with this.

Getting back to my main theme, it is all about whether or not a company can afford to pay their dividends. A company’s ability to pay dividends will ultimately lead to higher stock prices over time.

Like the Investopedia site, most sites give a definition of Dividend Payout Ratio using Earnings. See Investopedia. I do not think that this is a bad thing to do, but I also feel that you should go beyond this. As I had already said, I look at DPR for both Earnings per Share (EPS) and Cash Flow. If I see problems, I look beyond this on an individual stock basis. Also, for REITs, I look at a DPR on Funds from Operations (FFO). (I used to also look at FFO for the old income trust companies.)

Dividend payout ratios vary widely among companies. Stable, large, mature companies (like TSX-BCE or TSX-TRP) tend to have larger dividend payouts. However, with a more growth-oriented company it will tend to keep their cash for expansion purposes, have modest payout ratios. This would be companies like Saputo (TSX-SAP). In fact a lot of consumer stocks have low payout ratios.

Also, dividends are paid with cash and not with earnings. This is why a lot of analysts check the dividend payments against things like Free Cash Flow. See Investopedia for a definition of Free Cash Flow. Others check the dividends against Funds from Operations (FFO) or Adjusted Funds from Operations (AFFO). For a definition on FFO see Investopedia and also Investopedia for a definition of AFFO.

For an example of calculating FFO, see Investing Answers. This site also discusses the difference between FFO and AFFO. Some REITS pay as high as 90% of the FFO in distributions, but others keep the ratio lower (say 60%). If a REIT is paying 90% of the FFO, it is basically paying all its profits in distributions.

Analysts talk about DPR for Earnings at 60% and below and DPR for Free Cash Flow at 80% and below and 40% or lower for Cash Flow. The best companies have cash flows that are higher than earnings.

In the Investing Daily blog is an article on why you should use cash flow values in your DPR. See Investing Daily.

There are sorts of perspectives on this ratio and all sorts of blogs mentioning this ratio. See these articles by Dividend Guy, Million Dollar Journey, Dividend Money, The Market Capitalist and Dividend Ninja, Wiki Fool.

Next week, I will go back to talking about utility type stocks, including ATCO (TSX-ACO.A), Canadian Utilities (TSX-CU) and Innergex Renewables (TSX-INE).

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website for stocks followed and investment notes. Follow me on twitter.

2 comments:

  1. Susan,

    You are correct that we should focus on the dividend income and not on the portfolio value.

    During the financial crisis, most stocks were down big time in early 2009. TD went to $30 and since went up to $85. RY dropped below $25 and went up to $60 early 2011. I knew at that time that if I put all I have into dividend paying stocks, I would be getting a big fat dividend income, although my portfolio value might still go down more.

    However, I never pulled the trigger. I thought some companies might cut their dividends or eliminate them altogether, and the stock prices would drop significantly. Some companies might follow the path of Nortel. So, I missed a big opportunity.

    Did you buy anything at that time? What were your thoughts of the market at that time?

    MML

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  2. I am usually fully invested, so I do not have a lot of money to invest when we have recessions. In May 2009, I sold some Metro to buy TD bank at $47. Some of the prices of the banks were too good to keep passing up.

    Because of things like Nortel, I never let any one stock get too much of my portfolio. I did have Nortel, but sold half at $85 in June of 2000 because I thought it was very over priced. Nortel had a past of soaring and crashing.

    I have had few company like Nortel. But, companies do go bankrupt. And, companies can get into trouble during recessions.

    The thing is, you can only lose what you invest. There is no limit to what you can make on a stock. So, if you do a reasonably good job of picking stocks,and your portfolio is reasonably diversified over a number of stock, your winners should more than cover any losers.

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