What is a good dividend payout ratio for a company? Is 70% too high? Does a company with a low ratio imply high dividend growth?
Using a concrete example, we’ll answer 3 simple questions to figure out if a company has a good dividend payout ratio that supports a healthy dividend. You can ask the same questions for any dividend company you’re interested in.
However, a payout ratio based on earnings may not be appropriate for companies with big depreciation. Cash flows instead of earnings are better used in such cases, including for REITs and MLPs.
What is the payout ratio?
The payout ratio is the percentage of earnings that are paid out to shareholders as dividends.
For example, Fortis Inc’s (TSX:FTS) is expected to pay out $1.525 per share of dividends in 2016. The company just hiked its Q4 dividend to $0.40 per share.
- Fortis’s originally quarterly dividend per share was $0.375.
- $0.375 * 3 + $0.40 * 1 = $1.525
Its earnings per share are estimated to be $2.17 in 2016. So, Fortis’s payout ratio is about 70%.
- Annual dividend per share / Earnings per share
- $1.525 / $2.17 = 0.7028
So, Fortis retained about 30% of its earnings to grow its business or repay its debt, etc.
A lower payout ratio implies a safer dividend than a higher ratio.
What is a high payout ratio?
Does Fortis have a high payout ratio? There are several questions to ask to determine if any company’s payout ratio is high or not. Here I’ll continue to use Fortis as an example.
- How does Fortis’s current payout ratio compare to its historical payout ratios?
- How does Fortis’s payout ratio compare to its peers’?
- Are Fortis’s earnings stable? Which sector or industry is Fortis’s business in?
Q: How does Fortis’s current payout ratio compare to its historical payout ratios?
Conveniently, Fortis shows its dividend history in a chart on its website, up to 2015.
Source: Fortis Inc’s website – Fortis Inc’s dividend history
Fortis’s dividend history chart shows that for the last 20 years, the company’s payout ratio has been between the extremes of 40-90%. The 2016 payout ratio of about 70% fits nicely in the middle, and its dividend likely sustainable.
Q: How does Fortis’s payout ratio compare to its peers’?
Comparable utilities include Emera Inc (TSX:EMA) and Canadian Utilities Limited (TSX:CU).
I used the same method above to calculate the 2016 payout ratios of Emera and Canadian Utilities, and I get:
- Emera’s payout ratio is 82%
- Canadian Utilities’s payout ratio is 61%
Fortis’s payout ratio fits in between the payout ratios of Emera and Canadian Utilities. So, Fortis’s payout ratio aligns with its peers’, and its dividend is likely sustainable.
Q: Are Fortis’s earnings stable? Which sector or industry is Fortis’s business in?
Companies in certain industries earn more stable earnings than others.
The more stable the earnings are perceived to be for a company, the higher the payout ratio it could have.
In my article on the safest dividends on the planet, it stated,
“Utilities typically generate very stable earnings because there’s a consistent demand for their needed products and services no matter how the economy is doing.”
Because of their earnings stability, utilities typically have higher payout ratios. In fact, it’s normal to see utilities paying out 60-80% of their earnings.
So, it’s no coincidence that Fortis, Emera, and Canadian Utilities are expected to pay out 60-80% of their earnings in 2016.
In the last 10 years, Fortis had positive earnings every year, it had earnings growth in 6 out of 10 years, and when it had negative earnings growth, it more than recovered its earnings in a year or two.
Does a low payout ratio imply faster dividend growth?
Can you expect a dividend-growth company with a low payout ratio to grow its dividend faster than a higher payout ratio company?
The payout ratio is just one component to determine dividend growth. Another essential component is earnings growth.
Actually, Fortis guides to increase its dividend per share by an average rate of 6% per year through 2021. It is no coincidence that the analyst consensus earnings estimates for Fortis in the next three to five years is 6.3-6.7%.
Dividend growth has a strong correlation to earnings growth.
For companies with low payout ratios and stable earnings, the payout ratio can play an important role in the dividend growth.
Here I’ll use Starbucks Corporation (NASDAQ:SBUX) as an example.
Starbucks increased its dividend per share at a compound annual growth rate (CAGR) of 30.5% in the last five years. However, its earnings only grew at a CAGR of 19.8% during that period.
Where did the excess dividend growth come from? You’ve guessed it — an expanding payout ratio. In other words, Starbucks paid a bigger percentage of its earnings as dividends.
From 2010 to 2015, Starbucks’s payout ratio expanded from 28% to 43%. For 2016, Starbuck’s payout ratio is expected to be just less than 43%.
Now, if Starbucks decides to maintain its payout ratio at the current level, then, its future dividend growth will entirely be dependent on its earnings growth.
The analyst consensus earnings growth estimate for Starbucks is just over 18%. So, investors can expect Starbucks to grow its dividend by about 18% a year in the next few years.
Summary / Takeaway
- A lower payout ratio implies a safer dividend than a higher ratio.
- The more stable a company’s earnings are, the higher its ratio can be.
- A ratio of more than 100% (i.e. paying out more than 100% of earnings) is not sustainable over the long term.
- In the short term, a company can have a ratio >100% by choosing to borrow or sell assets to pay dividends.
- A lower ratio can indicate faster dividend growth going forward.
- Earnings growth is more important than a low payout ratio because earnings growth lowers the ratio, which can lead to higher dividends.
- Keep in mind that the payout ratio is just one component to determine if a dividend is safe.
Here are more tips on how to look for safe dividends for your income portfolio.
If you like what you've just read, consider subscribing via the "Subscribe Here" form at the top right so that you will receive an email notification when I publish a new article.Disclosure: At the time of writing, I am long FTS and SBUX.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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