I’ve often made the point that one argument for owning stocks that pay a dividend is that, “at least you know the company is making money.”  In many cases this is the case, but in some cases it’s not quite true.  All investors seeking a dividend yield need to make sure to look past the dividend and to the dividend payout ratio to gauge the heath of a company’s dividend distribution.

The dividend payout ratio is how much, in percent, the company is paying out in dividends compared to its earnings.  If you were write this as a formula it would like like…

• Dividend Payout Ratio = Dividend Payout Per Share / Earnings Per Share

The easiest way to determine the payout ratio is to visit Yahoo! Finance, select “Key Statistics” and scroll down until you find a section titled “Dividends and Splits.”  The section will contain a percentage to the right of the “Payout Ratio.”  If a company doesn’t issue a dividend, then you’re not going to see a percentage.  For example, Altria (MO) currently has a payout ratio of 77%….they pay a regular dividend.

You can also look at actual dividend distributions and calculate it against earnings per share based on the same time-frame for both figures.  It’s not the most difficult calculation in the world, but clicking 3 times is easier and faster….

What you need to keep in mind when investing is that even when a company has consistently paid a dividend for X number of years or quarters, their track record is at risk if they’re near, at, or over 100% in terms of their payout ratio.  For instance, using a stock pile of cash for a dividend distribution might be fine, if it’s a one time special distribution, but if it’s being used to prop a regular dividend payment, then you’re dealing with an unsustainable situation.  If a company payout ratio is at 98%, then a small margin of error exists before the dividend will be thrown over 100%.

If you’re seeing extremely high dividend payout ratio figures, you might want to dig deeper to see what the company is up to.  For instance when I see MO paying out 77% of earnings as dividends, it doesn’t concern me much.  Yes, they’re retaining less than 25% of their earnings for expansion or other endeavors, but they’re in a business that is established and stable.  That makes sense to me.

Make sure to check the payout ratio when investing in high yield stocks.  You do not want to have a false sense of security.  Again, risk matters when investing.