With bond yields at record lows, many investors are looking to dividend-paying stocks as a means of generating investment income. When a company starts paying a dividend, the market expects it to maintain the dividend going forward, and the stock price will be punished for any reduction in dividend. A stock with a high dividend yield is not a bargain if it surprises investors with a dividend cut. Therefore, if you are looking to buy a dividend-paying stock, you want to evaluate the safety of the dividend—that is, the likelihood that the company will maintain or increase the dividend going forward. One way to do this is to analyze how much of the company’s earnings are paid out in dividends to shareholders. The payout ratio allows investors to see how much of a company’s earnings is being used to fulfill dividend payments. It measures the amount of net income that is paid out as dividends to common shareholders, expressed as a percentage. The payout ratio calculation is as follows:

Dividends per share ÷ earnings per share

Interpretation

The payout ratio can provide clues to a company’s dividend policy and stability, the safety of the dividend and the company’s stage of growth. If a company is in its growth stage, management is most likely using its net income to reinvest in the company and therefore most likely not paying a dividend. Some growth firms will institute a token dividend in order to be classified as a dividend payer. Growth stocks typically have either a low payout ratio or no payout ratio.

When analyzing the payout ratio, it is important not to view a company in isolation. A company’s payout ratio should be compared to that of the industry in which it operates when judging whether it is high or low.

The payout ratio should also be tracked over time to spot any changes in trends. Many companies set a target payout ratio, which indicates management’s confidence in earnings and stability. Typically, the more predictable the earnings are, the higher the payout ratio the company can maintain.

Comparative Analysis

As shown in Table 1, Microsoft Corp. (MSFT) paid out a dividend of $0.83 per share in 2012, and their diluted earnings per share was $2.00, giving the company a payout ratio of 41.5% for 2012. This means that for every dollar of net income, 41.5% was paid out as dividends to shareholders. Microsoft operates in the software & programming industry, which has a median payout ratio of 0%. Microsoft is a part of an industry that typically reinvests their profits into the company to fuel growth. Why is Microsoft different than its peers? This should be part of your analysis. Also, notice that Microsoft’s earnings per share have increased annually, and its dividends per share more than doubled between 2006 and 2012. The industry median dividend payout ratio of 0% tells us something about Microsoft’s overall maturity and level of sustainability. The company looks to be comfortable using its net income to pay dividends to investors, but still has cash flow for research and development. The payout ratio remained relatively flat in recent years, with a spike between 2011 and 2012. This is a sign of a stable dividend. A steady payout ratio for Microsoft is a plus because it leaves room for consistent dividend growth. Earnings are typically the variable component of the payout ratio and therefore typically the source of an unstable payout ratio. Therefore, a stable payout ratio can be a sign of stable earnings.

Table 1. Payout Ratios for Microsoft Corp.

An extremely high dividend payout ratio suggests that a company might be paying out more than it can sustainably afford. Companies don’t actually use earnings to pay dividends, they use cash on hand, and sometimes they take on debt to pay the dividend. However, if a company consistently pays out more than it earns, this is a warning sign. It could lead to not enough money being put back into the business to maintain any level of growth, or the dividend payment having to be reduced. For a dividend to be sustainable, the amount paid out to shareholders must be well covered by the amount of cash coming into the business.

A dividend payout ratio above 100% means a company is paying out over 100% of their net income to shareholders. This can be very destabilizing over the long term. If a company isn’t reinvesting in itself, what will push its growth? A company can’t pay a dividend over 100% indefinitely; that’s why a high payout ratio is a sign of an unstable or unsustainable dividend.

Time Series Analysis

An example of this is provided by The Dow Chemical Co. (DOW) in Table 2. You can see that in 2008, they were paying 271% of their net income to shareholders in the form of dividends. Investors who were expecting that $1.68 per share annual dividend in 2009 had a rude awakening when the company only paid a total of $0.60 per share for the year. The company’s financials could not justify a dividend payout ratio of 271% during a time the future outlook for the firm was less than optimistic. In 2007, management announced a series of moves to restructure the company. The goal was to exit the automotive sealers business in 2008 or 2009. Dow also agreed to purchase the Rohm and Haas Company for $15.4 billion, in an attempt to move into the specialty chemicals industry, which carries higher profit margins. Where did the money for this acquisition come from when Dow was borrowing in 2008 to pay 271% of their net income to shareholders? It wasn’t coming: In 2009, Dow announced that the purchase of Rohm and Haas Company would not be completed on time. To fund the acquisition, the company had to drastically cut its dividend payment. Between 2008 and 2009, in addition to the dividends per share decreasing, earnings per share declined as well. Both 2008 and 2009 had payout ratios well above 100%. After the acquisition in 2008, and the economic crisis, Dow was forced to reduce their annual dividend.

The payout ratio for 2008 served as a warning sign to investors. But we can also compare the payout ratio of Dow Chemical to the industry in which it operates, plastic and rubber chemicals, to see the instability of Dow’s dividend payments. That doesn’t mean that this company is unstable overall, or a poor company to invest in, but rather that their dividends have been unstable and at some times unsustainable in the recent past. The payout ratio is an indication of what the company is doing with their money, so a significantly high payout ratio could mean poor financial management.

Table 2. Payout Ratios for The Dow Chemical Co.

Conclusion

Overall, the payout ratio can tell us quite a few things about a company. We can analyze the reliability of future dividend payments, the growth stage of a company and the financial management of the firm. Investors who look to dividend payments to supplement their income need to be aware of warning signs that show an “unsafe” dividend. Just because the dividend payment is increasing annually doesn’t mean that it will continue to increase.

Looking at Microsoft’s payout ratio over the past seven years showed us a stable dividend for a mature company. Dow Chemical had a payout ratio well over 100% at one point, which tells us that their dividend payment was unsustainable.

The future is never predictable. It’s important to remember that there are many more aspects to valuating a stock or dividend payment. However, investors should be aware of any tool that will assist in predicting future dividend stability, and the payout ratio does just that.