A number of reasons exist as to why investors flock to stocks that pay a regular dividend. For investors with an inclination toward dividend stocks, the all-mighty dividend payout ratio exists to provide a reference point regarding historical financial performance verses historical dividend distribution (payout) information. The ratio is expressed as a percent and considers dividends paid out per share divided by earnings per share ($Dividends Per Share/$Earnings Per Share).
It’s always important to at least consider the dividend payout ratio when a company’s dividend payment is holding weight in your decision to invest in the company. When you see a company paying at, near or above 100% this could be a sign of trouble. Though not always the case, it’s at least a red flag. The dividend payout ratio provides a guidepost for investors to gauge the weight the company’s payout ratio is placing against the company’s earnings.
One way to further leverage the usefulness of the dividend payout ratio is to think of it as an axillary gauge. You can use the ratio to help better understand other information you’re seeing. How do you accomplish this feat?
Dividend investors generally enjoying seeing that the company they’re considering has a history of increasing dividend distributions. Such action is not only good because of increased payments for current shareholders, but also benefits owners because increases have the power to attract more prospective investors. In short, growing dividend payments draw investors like ants to sugar.
How, as a new investor in a company that regularly pays and has a history of growing their dividend, do you evaluate the soundness of the dividend and its future growth? A good start to providing an answer to both questions is through the dividend payout ratio. As a rule of thumb a company that has a payout ratio of around 50% or less is not likely to be financially stressing itself in maintaining its current dividend payout. Additionally, a company in such a position with a history of dividend increases is providing investors a signal that they have additional room to continue their historical dividend growth growth pattern.
A good example of what is discussed above is Chevron (CVX). Chevron’s last quarterly dividend increased from .72 to .78 cents per share (quarterly) and their dividend payout ratio is 26%. If you look back over the past 20 years you see that the company has a strong history of dividend payment increases. Though history doesn’t necessarily lead to a linear future, observing the low dividend payout ratio gives additional insurance to investors that the company is positioned in a way to continue their dividend growth pattern.
The dividend payout ratio is a simple but powerful ratio, especially for dividend focused investors. Remember to consider the ratio when evaluating the health of a dividend payment and its propensity to potentially be increased in the future.