The Wrong Question to Ask About Dividend Stocks

by Marc Lichtenfeld, Investment U Associate Investment Director
Wednesday, July 25, 2012

Now that my book Get Rich with Dividends is a bestseller, I’ve had a lot of requests to be interviewed by the media. And the first question the host always asks me when I mention a dividend-paying stock is, “What’s the yield?”

I don’t blame them. That’s usually the first thing most investors want to know. And it is important. If you’re going to achieve your financial goals by investing in dividend-paying stocks, you do need a decent yield.

But more important than the amount you’re getting paid is the likelihood that you’re going to get paid at all…

That’s where the payout ratio comes in.

The payout ratio is the percentage of earnings paid out in dividends.

For example, if a company has $100 million in earnings and pays out $50 million in dividends, the payout ratio is 50%. It pays out 50% of its earnings in dividends.

The payout ratio formula is simple:

Payout Ratio = Dividends paid/Net income

A Balancing Act

As an investor, you want to get paid as high a dividend as possible. However, as a long-term investor, you don’t want a dividend so hight that it’s unsustainable.

For example, if a company paid out 100% of its earnings in dividends and the next year net income falls, the company may have to lower its dividend. That would likely send the stock price lower and disappoint shareholders who rely on the dividend for income.

But if last year, a company had $100 million in earnings and paid out $50 million in dividends, for a 50% payout ratio – and this year, earnings fall to $80 million, it could still pay out that $50 million in dividends (or even raise the dividend if the company chose to).

To ensure that the dividend is safe, I look for stocks that have a payout ratio of 75% or lower.

Let’s look at an example from The Oxford Club’s Perpetual Income Portfolio.

Kimberly-Clark (NYSE: KMB) earned $1.8 billion in the last 12 months and paid out $1.1 billion in dividends for a payout ratio of 61%.

An investor can feel fairly confident that the dividend will be paid even if earnings fall since the company has only paid out 61% of its earnings in dividends.

Cash Flow is King

Now, that you understand the idea, let’s take it one step further. We’re going to use the same concept, but instead of using earnings to figure out the payout ratio, we’re going to use cash flow from operations.

Cash flow from operations is a more accurate gauge of a company’s ability to pay dividends. You see, earnings have several non-cash figures in the formula. Things like depreciation, amortization and stock-based compensation are accounting tools that affect net income but don’t represent actual cash that the company is earning or paying out.

Cash flow from operations removes non-cash items and is a more accurate indicator of how much cash the company took in over the quarter or year.

The formula for the payout ratio is the same. Just substitute cash flow from operations for net income. [Note: “Dividends paid” and “cash flow from operations” are both located on a company’s “Statement of Cash Flows.”]

Payout Ratio (using cash flow) = Dividends paid/Cash flow from operations

Using the Kimberly-Clark example, cash flow from operations is $2.6 billion, dividends paid is $1.1 billion (same as above) and the payout ratio using cash flow is 42%.

So you can see that Kimberly-Clark paid out just 42% of the cash it took in from operating its business, giving it plenty of room to grow the dividend (as it has for 40 years in a row), even if earnings and cash flow decrease.

How Safe is the Dividend?

Here’s another example of why you should look at cash flow rather than earnings when determining the safety of the dividend.

Over the past 12 months, Taiwan’s United Microelectronics (NYSE: UMC) earned NT$10.6 billion (NT$ = New Taiwan Dollar) and paid out NT$14 billion in dividends. That sounds unsustainable. The company is paying out over NT$3 billion more than it earned.

But when we look at its statement of cash flows, we see that cash flow from operations was NT$41.6 billion, in large part due to over NT$32 billion in depreciation and amortization (non-cash expenses that lower earnings).

So when we look at the payout ratio based on cash flow, it’s a very reasonable 34%.

The payout ratio, particularly using cash flow, will give you a good idea of how safe the dividend is.

A strong yield is great, but it hardly matters if it’s not safe. Now you know the first question to ask when researching dividend-paying stocks.

Good Investing,

Marc

Muddle Through Reminder

The S&P flew up to new highs in early April on the wings of strong economic data while Europe and China were kind enough to stay out of the headlines. The problem with this scenario is that some thought that the economy was more robust than it truly was. Recent weaker economic news, like today’s ISM Services showing, throws cold water on the notion of a hotter economy.

On the flip side, far too many people will now start to think that the weaker data means that we could be headed towards another recession. That is just stinkin’ thinkin’ too.

You see, Muddle Through Growth is what best explains what we have gone through the past 3 years…and it continues through this day. +2.7% growth is considered “trend” growth for US GDP. So Muddle Through is less. More like +2%.

At that pace it sometimes feels like you are about to hit a boom…but it doesn’t happen. And it sometimes feels like you are about to go into a recession…but that doesn’t happen either.

In the short run this scenario will create sideways to downward action. But most importantly, until proven otherwise, we are entering our 4th year of Muddle Through Growth. The last 3 years produced a 100% gain for stocks…I can think of worse outcomes 😉

If you are an active trader, then play the swings in near term. If you are a long term investor, then stay focused on the highest probability outcome, which is that the bull run remains intact.

Best,

Steve Reitmeister (aka Reity…pronounced “Righty”)
Executive VP, Zacks Investment Research