Hope you’re all having a great week so far!
On my last post, I shared Part I of a mini-series on Dividend Investing. In today’s post we’ll dive a bit into an important metric you should be aware of when it comes to choosing dividend stocks.
I’ve also received a few questions from all of you (amazing questions by the way!) and I plan to elaborate more on those during part III (and final part) of the series.
By the way – I’ve also answered some questions already in the Facebook Group! You can check under the comments section of the post for Part I for some answers.
Let’s continue …
One of the topics covered in last week’s post was dividend yields or the “interest rate” a dividend paying company would pay YOU, usually on a quarterly basis, simply for owning the stock.
Since dividend yields are payments the investor would receive, some people might be under the impression that the higher the dividend yield or payment the better the investment. Some might also assume that simply finding dividend stocks that pay the highest yields is the way to go.
I am here to tell you this is a very erroneous way to go about investing in dividend-paying stocks.
A high dividend yield should never be your sole determining factor when researching dividend paying stocks.
The truth of the matter is, there are several factors an investor should look into when researching a prospective investment that pays a dividend. One of those important factors is the company’s Dividend Payout Ratio.
The Dividend Payout Ratio (also known as ‘DPR’ or ‘Payout Ratio’), is simply a metric that tells you what is the percentage of profits a company is paying out in dividends to their shareholders.
If you remember from my last post, I explained that dividend payments come from the profits a company generates – what is left over after all expenses are taken care of. A company can choose to keep those extra funds and invest them back into the business and/or they can compensate shareholders in the form of dividend payments.
The formula for DPR is simple.
Yearly Dividends Per Share/Earnings Per Share
However, you can also easily find this metric under the “Dividends & Splits” or “Ratios” section of a company’s data page on a site like Yahoo! Finance or similar sites.
In the chart above, the company has a Payout Ratio of 54.82%. That means the company pays out 54.82% of its profits in the form of dividends and keeps 45.18% (100-54.82=45.18) inside the company in order to invest in projects, products, or services that can help the company remain strong and competitive.
Now, let’s look at an extreme – you examine the dividend payout ratio of another company – “Investor Corp” – and notice their dividend payout ratio is 110% – this means that the company is keeping nothing in-house to invest back in the business and is likely incurring debt in order to pay dividends – which would be a huge red flag in my eyes.
Now, you may be wondering what percentage would be considered ‘reasonable’. Generally speaking, a Dividend Payout Ratio 70% or lower is a healthy ballpark.
However, it is also important to note that you may notice that older, more mature businesses may have ratios in the ballpark of 80% or higher in some cases. This is usually normal. Think about it – an older, more established company doesn’t have to invest a lot of money in growth and development so, they get to pay out more to investors.
With that said, remember that every company is different and you have to take a very close look at the business as a whole when you are examining Payout Ratios.
And this is it for today’s post! As a mini homework assignment I challenge you to find the dividend payout ratio of a company on your watch-list and let me know what that is in the comments. Take it one step further and tell me what you can conclude from that number.
You can also leave your comments below and/or join the discussion over at the Facebook Group. 🙂
Have a fantastic week! Cheers to profits.
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