- low payout ratio does not suggest lots of room for dividend growth
- companies with wide economic moats are more likely to continue to grow dividends
- companies with strong balance sheet strength are more likely to continue to grow dividends
Low Payout Ratio does not suggest there’s plenty of room for Dividend Growth
The payout ratio is the amount of earnings paid out in dividends to shareholders. Just because a company has a low payout ratio does not imply that it will continue growing its dividends. Businesses in stable industries tend to have higher payout ratios. For example, it is normal for industries like consumer staples, tobacco, and utilities to have relatively higher payout ratios of 60-70%. Companies such as Coca-cola (NYSE:KO), Philip Morris (NYSE:PM), and Wisconsin Energy Corporation (NYSE:WEC) come to my mind. On the other hand, if a company had higher earnings variability, it would need a higher cushion for the dividend in periods when the company’s profitability is challenged. That is, such a company would have a lower payout ratio. Thus, the payout ratio is just one of the metrics which help determine if the dividend is safe and has potential to grow.
A good way to tell if a company is meant to have a low payout ratio or not is to simply compare its payout ratio to its peers’ payout ratio. Since they’re in the same industry, they’d want to have a similar amount of cushion for their dividends. For instance, Ross Stores (NASDAQ:ROST) and TJX Companies (NYSE:TJX) are both in the cyclical business of apparel retails. Ross has a payout ratio of 16.5, while TJX’s is 13.7. If both companies decide to keep the payout ratio in the teens, the only way they can grow the dividend is to rely on earnings growth. So, estimating the earnings growth of a company becomes a good exercise to help determine the safety of a company’s dividend and its growth.
Of course, a company can choose to grow its dividend at a faster rate than its earnings growth. In this respect, other than with the “help” of earnings growth, the company must raise its payout ratio. An example that I noticed is Qualcomm (NASDAQ:QCOM). It recently grew its dividend by 20% from an annual payout of $1.40 to $1.68, while this year its earnings growth estimation is around 15%.
Companies With Wide Economic Moats are Likely to Continue to Grow Dividends
Companies with economic moats have one or more competitive advantages over peers, and that a wider economic moat protects dividends over long periods of time. Matthew Coffina, from Morningstar, talks about Building a Moat in your Portfolio (pdf link to his slides) from March’s Individual Investor Conference. He lists the 5 sources of a moat:
- Network Effect – the value of a company’s service increases as more people use it
- Intangible Assets – patents, brands or regulatory licenses which protect excess returns
- Cost Advantage – economies of scale, access to a unique asset
- Switching Costs – it’s too expensive for customers to stop using a product
- Efficient Scale – a niche market is effectively served by one or a small handful of firms
A company with a wide moat has multiple competitive advantages over its competitors. For example, I think that Coca-Cola’s moat comes from having intangible assets, cost advantage, and possibly efficient scale, as Coca-Cola is a world-renowned brand, and selling its products in more than 200 countries through its distribution system, and the only other big player is Pepsi (NYSE:PEP).