Why is the dividend payout ratio important?

Morningstar's director of equity-income strategy believes that the payout ratio is the most important statistic for dividend investors.
By Morningstar |  01-12-15 | 

Mint analysis of BSE-100 companies based on Capitaline data found that the dividend payment ratio rose to 34.52% in 2014-15. This is the highest such figure since at least 2004-05.

Of these 100 companies, the dividend payout ratio of 78 private companies rose to 34.02%—the highest in at least 11 years—while that of 22 state-run companies fell slightly to 35.40% from 38.49% a year before, still the second highest in at least 11 years.

It appears that Indian companies rewarded their shareholders as they saw no reason in saving the money for capital expenditure in an economy starved of demand.

Josh Peters, editor of the Morningstar Dividend Investor newsletter and director of equity-income strategy, believes that the payout ratio is the most important statistic for dividend investors.

Morningstar’s markets editor Jeremy Glaser posed a few questions to him.

Let's start with what the payout ratio actually is and why you think it's more important than yield.

Payout Ratio defined is simply the dividend rate of a company divided by the earnings. So, thinking about it very simply, if a company pays out, say, Rs 2/share and has Rs 5/share of earnings, two divided by five is 0.4, or 40%. That's your payout ratio.

The reason I find the payout ratio to be even more powerful than the dividend yield is that dividend yield is partially to mostly--depending on the situation--a valuation statistic. If the stock price is high or low, it's going to correlate to a low or high yield, all else being equal.

The payout ratio goes a little bit further.

There is a big, strong correlation between high payout ratios and high dividend yields; but the payout ratio is also going to give you a sense of perspective that the company is or is not devoting a significant share of its earnings to the dividend, and it provides you with a framework for evaluating whether or not that dividend is safe and likely continue to grow.

You talk about safety. But how do you know when a high dividend payout ratio is a sign that management is devoted to the dividend versus they're really strapped for cash and they are going to have cut it soon?

That's why I don't have any hard-and-fast rules when it comes to payout ratios--I know there are some investment strategies, indexes, and index products that do. They'll simply say no payout ratios if they are over 60%. Well, there are some great companies that have payout ratios of 75% or 80%.

What you need to do, in fact, is to not just have a hard-and-fast rule but to use that statistic to evaluate the business. When I see a payout ratio like that from a company, I think about how stable the earnings are, first of all, and then how much earnings vary--how much did earnings drop in the last recession? What is the company’s debt and cash position - can they afford to maintain this dividend? Is the company in a position to pay out a big dividend and continue to grow the business at the same time?

You want to put a company through the wringer to make sure that whatever payout ratio is there provides that balance. You want to make sure you've got a margin of safety against something going wrong, cyclicality in the earnings, or some other kind of problem, as well as being able to provide for that long-term growth. Even if a stock yields 3%, 4%, or 5%, if the dividend doesn't grow, that's a lousy total return.

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