Updated: November 2, 2016
Dividend cuts hurt your portfolio in lost income and likely great unrealized capital losses. There are ways to lower the chance of dividend cuts — by looking for companies that pay safe dividends. Here’s how you can go about doing it.
Does a low payout ratio suggest faster 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%. Examples include Coca-cola (NYSE:KO), Philip Morris (NYSE:PM), and Wisconsin Energy Corporation (NYSE:WEC).
On the other hand, if a company has higher earnings variability (bumpy earnings), it will need a higher cushion for its dividend in preparation for periods when the company’s profitability is challenged.
In other words, such a company will have a lower payout ratio. Thus, the payout ratio is just one of the metrics which helps 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 compare its payout ratio to its peers’ payout ratios.
Since they’re in the same industry, they’d 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 19%, while TJX’s is 25%. If both companies decide to keep their payout ratios where they are, the only way the apparel retailers can grow their dividends 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 potential.
I’d argue that in the medium term, Ross has the ability to grow its dividend per share at a faster rate than TJX because the former has a lower payout ratio and is expected to grow its earnings per share at a faster rate.
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.
Amgen, Inc. (NASDAQ:AMGN) is one example. Its dividend is 26.5% higher than a year ago, but its earnings growth was “only” 19% in 2015. Read More