Dividends are always welcome by shareholders, but not all dividends are created equal. What I mean is that investors have to carefully scrutinize a company’s dividend payments to assess if they are sustainable. One useful method is to look at the dividend payout ratio. The level of the ratio can provide may useful insights into a company’s use of cash and also its plans for growth. In this article, I will dive into three broad categories of the dividend payout ratio and their implications for us as investors.
Knowing the payout ratio
The dividend payout ratio is defined as the ratio of a company’s dividend per share to its earnings per share. For example, a company paying a dividend of $0.10 per share with $0.20 in earnings per share has a payout ratio of 50% ($0.10/$0.20).
The payout ratio of 50% implies that the company is paying out $0.10 per share of its earnings as a dividend while retaining the remaining $0.10 to reinvest for growth. A company can theoretically only pay out what it has earned. Companies with a payout ratio exceeding 100% are drawing on past reserves to pay out their dividends – it’s not a good idea as doing so would erode the equity base of the companies if they carry on that course of action.
Payout ratio of 0%: A pure growth company
Companies which do not pay a dividend are considered as pure growth companies, as they are reinvesting all their profits to grow their businesses.
Not paying a dividend makes sense if a company is experiencing high levels of growth, and is able to reinvest its cash to attain a high return on invested capital (ROIC). By reinvesting the cash, the growth in the company’s earnings and cash flows would eventually translate into better valuations and a higher share price. As investors, we can enjoy good capital gains by investing in such companies and holding onto them.
Payout ratio between 20% and 80%: Growth plus yield
Companies which have a payout ratio in the range above play a dual role of rewarding shareholders with dividends, and also reinvesting some portion of their earnings for growth.
However, do note that such companies usually have a lower ROIC than pure growth companies, and their dividend yields are also not fantastically high (usually in the 2% to 4% range). To me, however, I am getting the best of both worlds: There’s some yield along with some growth.
Payout ratio of 80% or more: A yield company
A high payout ratio is a signal that a company has limited growth prospects, and that the company is turning into a cash cow. Investors would thus enjoy a good, steady dividend, but should not expect the company to grow its earnings meaningfully. Some examples of such companies in Singapore’s stock market are real estate investment trusts, which have a mandatory payout ratio of at least 90%. Some business trusts in the local market even pay out all their earnings as dividends (i.e. a payout ratio of 100% or more).
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.