The Dividend Payout Ratio

This article was published in the July/August 2011 edition of the Canadian MoneySaver, and is posted here with permission. For more information visit www.canadianmoneysaver.ca

The Dividend Payout RatioMany dividend investors go to great lengths to screen dividend stocks. If you stick with the big dividend aristocrats or other big blue chips, you will do just fine. Some of these companies have been paying dividends for over 50 to 100 years! The economic stability of a company like that, which also increases its dividends year after year, is money in the bank. This is what most dividend investors look for, and it is the basis of Dividend Growth Investing.

However, many good dividend paying stocks are not big blue chips with a significant dividend history, but may present good investment opportunity. They are usually higher yield stocks with smaller capitalization, but companies with a solid business plan, good management, and several years of operating revenue. The question is whether that company is a sound investment, and that is where having a set of pre-defined screening criteria comes into play.

One of the most important screening criteria I use is the Dividend Payout Ratio (DPR). This simple ratio tells me the ability of a company to pay its dividends to shareholders, and its ability in the future in continuing to do so. The DPR also tells me whether a company has the potential to raise its dividend, or the likelihood that it may cut the dividend.  In this article I examine the DPR ratio, what it means for investors, and some brief examples.

It is important to note the Dividend Payout ratio should be considered with a range of other screening criteria as well, such as dividend yield, the liabilities-to-equity ratio (a measure of debt), and the price-to-earnings ratio, etc. However on its own, the DPR can indicate how a company manages its cash flow.

How to Calculate the Dividend Payout Ratio

The DPR is very easy to calculate. The key figures you need are EPS (earnings per share) and the dollar amount of the Annual Dividend. This information is easily obtained from the Globe and Mail and many other financial web sites.

Dividend Payout Ratio = (Annual Dividend / EPS) * 100

The Dividend Payout Ratio indicates how much of a company’s revenue goes into paying out its dividend to shareholders. For example a company with a Dividend Payout Ratio of 60%, would pay out 60% of its earnings as dividends to shareholders, while retaining the other 40%.  As a general rule the higher the dividend yield, the higher the DPR. Conversely, big dividend blue chips and dividend aristocrats have lower DPR with a lower yield.

At the time of writing, Rogers Communications (RCI.B-T) has an annual dividend of 1.42 / EPS of 2.64, therefore the DPR = 53.7%.  As another example, Wal-Mart (WMT-N) has an annual dividend of 1.46 / EPS of 4.19, so the DPR = 34.8%. The Royal Bank of Canada (RY-T) has a dividend payout ratio of 51.9% (2.00 / EPS 3.85). On the other hand Yellow Media (YLO-T) has a DPR of 120.3% (0.65 / EPS 0.54). YLO must leverage or provide an additional 0.20 cents for every 1.00 they distribute in dividends – a 20% shortfall. A dividend payout ratio over 100% usually spells trouble at some point down the road.

Why the Dividend Payout Ratio Is Important

Dividend Investors focus on the Dividend Payout Ratio, because it indicates a company’s ability to continue paying dividends, and the likelihood that a company will be able to increase its dividend in the future (dividend growth). The DPR can help to determine (1) if a company is paying all of its earnings to shareholders, (2) leveraging to continue paying its dividends, or (3) leaving extra cash flow for future expansion and operating expense.  Conversely it can also indicate a company that may cut its dividend, especially if its DPR is over 100%. That would indicate a company that pays out more in dividends than it earns.

Investors consider 30% to 60% as the ideal Dividend Payout Ratio. Dividend investors like to purchase stocks within this range as there is also room in the company for future growth, and possible dividend increases.  A company with a lower DPR such as 30% to 40% will have the potential to raise its dividend year after year. This after all is the basis of Dividend Growth Investing. Take a company like Coca-Cola (KO-N), which has a DPR of 52.8% (1.88 / EPS 3.56), or the example of Wal-Mart (WMT-N) above with a DPR of 34.8%. Both these companies are solid blue-chips which raise their dividends.

A Good Dividend Payout Ratio = Good Management

Big companies realize the necessity of keeping cash for general revenue, as well as for future growth. They reward shareholders through a reasonable dividend yield, 3% to 5%, but also keep cash to maintain their business. For this reason alone, in my opinion, a good Dividend Payout Ratio is also a reflection of good management – it shows a company that maintains fiscal responsibility.

Therefore when you see a stock with good fundamentals, but a high dividend payout ratio, you can be certain there is a long term issue behind the scenes. It could be the result of low earnings, declining sales, high debt, or even poor management. A high Dividend Payout Ratio should always be a red-flag!

Why Does a High Dividend Payout Ratio Spell Trouble?

The concern is a company with a high DPR, especially over 100%, may not be able to continue to meet its obligation to pay a dividend, since it must also pay its operating expenses and debts.  It may use leverage to make the difference (i.e. issuing more shares), or may simply cut the dividend. Many small caps with higher dividend yields, especially the previous Income Trusts, have very high DPRs over 70% to 80%, and in some cases over 100% (such as Yellow Media YLO-T). Dividends don’t come out of thin air, so when a company has a DPR over 100% investors should ask themselves – “Where is the money for dividend coming from? Is this a company I really want to invest in?”

The risk is once the dividend yield of a company rises over a reasonable level, and the DPR is over 100%, a company will be left with no option other than to cut its dividend. Companies avoid cutting dividends at all costs, since they lose investor confidence, and that will result in a sell-off of shares and loss in equity. However companies can’t operate effectively with a high yield either, if all their revenue is paid out in dividends. So it’s a real “Catch 22” when a company ends up in this corner.  Often a company in this situation is left with no alternative but to cut the dividend.

Case in point, TransAlta (TA-T) was a company I was reviewing with its dividend yield of 5.5%, when it was recently just below $20 per share. I think TransAlta is a solid utility with good management. However, its current DPR is 117% (1.16 / EPS 0.99). That means TransAlta must provide an additional 0.17 cents for every dollar it pays out in dividends. If TransAlta wants to expand or requires further investment, then it will either have to borrow more or cut the dividend at some point.  There’s been speculation around for years regarding a cut in the TransAlta dividend, and a reader on my blog already indicated TransAlta previously cut their dividend many years ago.

If you think companies don’t cut dividends then think twice!  Back in early December after converting to a corporation from an Income Trust, Canadian Oil Sands (COS-T) cut its dividend some 60% down from 8.10% yield to 3% yield. However the cut was a good move for COS. Although its share price initially plummeted some 15% as investors dumped their shares, the company was a quick turnaround with surging oil prices and interest in the oil sands sector. COS now has a dividend yield of 4.10% (half of what it used to be) and a DPR of 55.8% (1.20 / EPS 2.15).

Yellow Media (YLO-T) is another company in trouble with a DPR over 120% (0.65 / EPS 0.54). This is not a good Dividend Payout Ratio, since Yellow Media must leverage an extra 0.20 cents for every $1.00 in dividends they distribute.  Although the company has virtually no debt and a low Price to Earnings ratio, a DPR over 100% was the giveaway trouble was looming. Now the dividend yield is at 18.10% with a crashing share price.

What if the Dividend Payout Ratio Is Too Low?

Conversely some companies have a very low Dividend Payout Ratio, less than 30%. These companies will also have a low dividend yield.  Companies such as these may want to keep cash for future expansion and other reasons that may not be apparent.

If you are investing in a low yield and low DPR company, then you are relying entirely on capital growth for your investment.  That’s not to say that stocks that don’t pay dividends (or low dividend yield) are not good investments, or have less growth. Teck Resources (TCK.B-T) for example has a dividend yield of only 1.30%, but its share price soared from a low of $3.90 in March 2009, to over $62.22 in January 2011. In fact many small caps, and low dividend yield stocks have outperformed the large dividend payers in capital appreciation.

However it’s worth noting, that during the financial crisis of 2008 and 2009, those investors who held dividend stocks and stayed the course were still receiving their dividend payments. Although they endured great stress from the crisis, they were still receiving their dividends, and were able to recoup most of their losses from the ensuing market rally in 2009 and 2010.

The Top 20 Canadian Companies (by DPR)

Here are the Top 20 Canadian companies based on the lowest Dividend Payout Ratio, with a market capitalization above 500M, and a dividend yield from 3.0% to 7.0%. I’ve also listed the P/E Ratio (Price-to earnings), and the L/E Ratio (liabilities-to-equity) as a measure of overall debt.

For the L/E ratio a value of 1 or below is considered a good measure. That means Brookfield Office Properties (BOX.UN-T), Emera (EMA), Sunlife (SLF-T), Rogers Communications (RCI.B-T), and TMX Group (X-T) currently carry high debt.

These stocks are listed on the TSX (Toronto Stock Exchange). This data was compiled on July 6th, 2011.

Company Symbol Price Div Yield P/E Ratio L/E Ratio Dividend EPS DPR
Brookfield Properties Inc. BPO 18.54 3.0% 6.12 1.17 0.55 3.03 18.2%
Transcontinental Inc. TCL.A 14.09 3.1% 6.87 1.00 0.44 2.05 21.5%
Brookfield Office Properties BOX.UN 22.70 4.2% 6.43 5.22 0.96 3.53 27.2%
Genworth MI Canada MIC 26.35 4.0% 8.39 1.06 1.04 3.14 33.1%
Laurentian Bank of Canada LB 45.10 3.7% 9.45 N/A 1.68 4.77 35.2%
Emera Inc. EMA 31.58 4.1% 10.49 2.57 1.30 3.01 43.2%
National Bank of Canada NA 77.59 3.6% 11.83 N/A 2.84 6.56 43.3%
Toromont Industries TIH 19.96 3.2% 14.57 0.80 0.64 1.37 46.7%
Bank of Nova Scotia BNS 57.70 3.6% 13.05 N/A 2.08 4.42 47.1%
TD Bank TD 79.60 3.3% 14.37 N/A 2.64 5.54 47.7%
Sunlife Financial SLF 28.67 5.0% 10.28 10.43 1.44 2.79 51.6%
Royal Bank of Canada RY 54.40 3.7% 14.13 N/A 2.00 3.85 51.9%
Corus Entertainment CJR.B 19.96 3.8% 13.96 1.04 0.75 1.43 52.4%
Rogers Communications RCI.B 37.06 3.9% 14.25 3.78 1.42 2.60 54.6%
Bank of Montreal BMO 60.48 4.6% 12.00 N/A 2.80 5.04 55.6%
CIBC CM 77.10 4.5% 12.36 N/A 3.48 6.24 55.8%
Canadian Oil Sands Trust COS 29.95 4.1% 13.93 0.84 1.20 2.15 55.8%
Northern Property REIT NPR.UN 29.71 5.1% 11.34 1.45 1.53 2.62 58.4%
TMX Group X 44.09 3.6% 16.70 2.85 1.60 2.64 60.6%
Torstar Corp. TS.B 11.90 4.2% 15.45 1.18 0.50 0.77 64.9%
Averages     3.9% 11.80 2.57     46.2%

Disclaimer:  This table is not intended as a recommendation to buy the individual securities mentioned. I am long on Royal Bank (RY-T) and Rogers Communications (RCI.B).

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32 Responses to “The Dividend Payout Ratio”

  1. MoneyCone

    Jul 20. 2011

    Excellent intro to DPR, DN! I always look for this metric when screening for new dividend paying stocks.

    I wish Google Finance, my favorite finance site, showed this ratio along with other dividend metrics. Just to get this I use AOL finance instead.

    Very useful metric indeed.

    Reply to this comment
  2. Andrew Hallam

    Jul 20. 2011

    Ninja, this post rocks!

    It’s timely, because many people recently are getting drunk on high yields, without recognizing how temporary they can be if the company can’t sustain the dividend.

    Here’s something I think you might find fascinating:

    Two scenarios. A 30 year old invests $10,000 and leaves it in an index or a group of dividend paying stocks. He or she reinvests the dividends, and opens their account 35 years later. Assume a 5% dividend growth increase each year, and assume an average PE ratio, when the investor begins, of 12X earnings, with an initial dividend yield of 3%.

    Which of the below scenarios would ensure the larger account size after 35 years?

    A. The $10,000 investment turns into $5000 at the end of one year, and the prices of the stocks (or the index) remain the same (depressed) for 35 years, while dividends are reinvested.

    B. The $10,000 investment turns into $20,000 at the end of one year, and the prices of the stocks (or the index) remain the same for 35 years, while dividends are reinvested.

    You can guess the right answer. It’s not what you’d think.

    Reply to this comment
  3. Very nice post on the dividend payout ratio! It’s definitely a key metric to monitor for sustainability and future growth.

    Reply to this comment
  4. The Dividend Ninja

    Jul 20. 2011

    MoneyCone, Andrew Hallam, and Passive Income Earner, thanx for posting and the feedback :)

    Andrew, I don’t know the answer to the question. The possible answer is it is the same amount either way (since yield and share price are proportionally related).

    Reply to this comment
  5. Dividend Mantra

    Jul 20. 2011

    Great intro to the payout ratio, Ninja.

    I would agree with you that 30%-60% is a “sweet spot” for this metric, and I really prefer as close to 50% as possible, as low payout ratios do leave a lot of room for growth, but could also potentially mean management is a bit stingy with the payout.

    Good stuff!

    Reply to this comment
  6. Andrew Hallam

    Jul 20. 2011

    Hey Ninja,

    The long term scenario A is better.

    If the market’s level gets cut in half, the immediate dividend yield doubles. In the case above, it would double to 6% (much like dividend yields were in the mid 70s) If the price level of the market fails to rise, and if the actual dividends grow by 5% annually, then the yield increases by 5% annually as well. A 3% year in one year, becomes a 3.15% yield the following year (as long as the market level doesn’t rise). When the market level stays depressed, the reinvested dividends work magic, buying low priced shares with a high yield, giving this an incredible long term effect.

    After reading about one of William Bernstein’s professor friends teasing students with a “What scenario would be better for you?” I decided to run the numbers myself.

    Long term, of the scenarios I presented in my first comment on this point, you would ironically make far far more money having the markets cut in half, and reinvesting dividends for 35 years, than you would if the markets doubled, stayed at that point for 35 years, and you were able to reinvest the dividends. It’s counterintuitive, but if you do the math, you’ll see that Bernstein’s old buddy was right.

    Reply to this comment
  7. My Own Advisor

    Jul 20. 2011

    Ninja, this post was great.

    I also liked the MoneySaver version ;)

    The best thing about this post/article, you highlighted how this metric can be easily understood and applied. Chasing yield is never a good idea. Sure, having the odd stock (like TransAlta, ahem, I own it) that has a high payout ratio is OK, but I would never keep most of my portfolio in those high-yielding companies. Just doesn’t make sense to chase yield from a risk/reward perspective. Unless of course, you like the burn a high-risk stock could very well provide just like our hot Ottawa weather of late!

    I think a healthy DPR for an established dividend-payer is about 50% – that’s a great target to shoot for. Thoughts?

    Cheers,
    Mark

    Reply to this comment
  8. The Dividend Ninja

    Jul 20. 2011

    Andrew, fascinating! I initially thought A might provide a higher return, but I just wasn’t sure enough to stake a claim on it. The missing key was how much the yield would increase with the drop in share price. Your comment also rocks, “many people recently are getting drunk on high yields..”

    Mantra you’re right, many companies that introduce a dividend or pay a very low dividend could be far more generous than they are. I’ve never really understand why a company even bothers offering a 1% to 1.5% dividend. Perhaps they make more with share buy backs ;)

    MOA, you bring up a great point about “chasing high yield”, something many investors still don’t understand: high yield = high risk. Even more than that, high yield also equals less ROI (Return on Investment) becuase the higher yield results in much less capital growth. Cheers!

    Reply to this comment
  9. My Own Advisor

    Jul 22. 2011

    You raise a good point, low-yield dividend-paying stocks…say around 1%. Why bother?

    I think I need to work on a post about that, share buybacks vs. low-yield dividend companies.

    Which one would investors prefer? Personally, I wouldn’t own many stocks that don’t yield at least 2%. I am after all owning these dividend-paying companies for, well, dividends.

    I know in talking with Derek Foster, he’s a big fan of IMO but they yield about 1%.

    Reply to this comment
  10. I think Shoppers Drug Mart (SC) fall in that category. Interestingly, they have raised their dividends regularly. CP and CNR are both on that list too. These are quite good companies and well managed and I have stayed away due to the lower yield compared with other opportunities. Both SC and CNR are Canadian Dividend Aristocrat.

    Reply to this comment
  11. The Dividend Ninja

    Jul 22. 2011

    PIE, thanx for posting. Generally as you know, lower yield stocks have the potential for higher growth, and vica versa. But there are always excpetions of course. That’s why its nice to have a basket of diffrent kinds of dividend payers – don’t you think?

    You can’t go wrong with CP or CN, railroads are a neccessity. You will earn an nice ROI over the long term.

    SC (Shoppers Drug Mart) may be an aristocrat, but I took profits at $40 a few months ago. There is just too much uncertaintity around cutting costs by provincial governments in healthcare – by legislating the use of generic drugs over prescription drugs. Approximately 47.6% of total sales for Shoppers is through their dispensing fee and prescription sales, and any cuts in this segment really impacts their bottom line (in my opinion).

    Reply to this comment
  12. Think Dividends

    Jul 25. 2011

    Two comments:

    1) DPR the way you described is good for 95% of the companies out there. For example, EPS is meaningless for REITs. Distribution / AFFO (adj funds from operations) is the correct way to analyze this sector.

    2) Canadian Oil Sands: Management’s policy (it is stated on their website) is to have a “variable dividend policy”. COS investors “should” know this point (but a lot of investors don’t). Dividend hikes and cuts are tied to the price of oil. Several firms outside of North America have variable dividend policies. Westshore Terminals (WTE.un) is another Canadian example.

    CHEERS

    Reply to this comment
  13. The Dividend Ninja

    Jul 25. 2011

    Think Dividends,

    Thanx for dropping by and posting. If I’m not mistaken,the dividend-cut for COS back in December was due to its conversion to an income trust. Managment was smart enough to realize the yield was unsustainable in the Corp tax structure vs the Income Trust tax structure.

    Point 2 is a good point I was not aware of, so that’s a good reminder for investors to check for this info before investing ;)

    Cheers!

    Reply to this comment
  14. Think Dividends

    Jul 26. 2011

    The COS December cut was partly due to corporate taxes and partly due to lower crude oil prices.

    Quote: “COS today declared a dividend of $0.30 per Share payable on August 31, 2011 to shareholders of record on August 25, 2011. COS has a variable dividend strategy; dividend amounts will vary over time depending largely on crude oil prices and the investment cycle of Syncrude’s capital projects.”

    CHEERS

    Reply to this comment
  15. Hi Ninja,

    Congratulations on getting published in the MoneySaver!

    Great article!! Dividend Payout Ratio is very important, and it’s the first indicator I look for before starting any research. I also keep an eye on the DPR after I’ve purchased because it could be an early warning sign of trouble if it gets too high.

    Reply to this comment
  16. The Dividend Ninja

    Jul 27. 2011

    Kanwal, Thanks! :)

    That is also an excellent point to keep an eye on the DPR. A rising DPR for example, may indicate future troubles emerging.

    Reply to this comment
  17. The Wealthy Canadian

    Jul 31. 2011

    Awesome post, and great work compiling the information!

    I always knew that Brookfield companies were extremely well managed but had not known that BPO & BOX had such low payout ratios. Interesting stuff.

    Emera is one of those stocks that I am really happy to own. Nice yield, great company.

    Laurentian Bank of Canada may lag some of the other banks in terms of growth prospects and so forth, but I’m glad I have a position. It’s nice to see it topped the banks in terms of payout ratio.

    Despite COS making the list, I was a little ticked off when they cut their distribution a while back and have not topped up on any shares since. If I recall correctly, they cut their distribution well before their conversion.

    An indicator I often use in analyzing stocks is seeing whether or not a company’s EPS covers it’s dividend.

    Great post.

    Reply to this comment
  18. The Dividend Ninja

    Jul 31. 2011

    Wealthy Canadian,

    Thanx for dropping by! :) Yes Brookfield often gets overlooked by dividend investors for some reason, but when it comes to professional management, I think you are bang on with that!

    Laurentian Bank was also on my buy list recently when I had some capital to invest, as they missed earnings just a while ago. That would have been a nice entry point, but its still trading at a good price.

    “An indicator I often use in analyzing stocks is seeing whether or not a company’s EPS covers it’s dividend.”

    Yup, that is exactly what the DPR will tell you ;)

    Cheers

    Reply to this comment
  19. The Wealthy Canadian

    Jul 31. 2011

    Yeah, it’s my usual quick & dirty test to get the gist of things…I really like how you took the time to lay all the specifics to the extent that you did.

    I hear you with LB. Rogers has come off a bit lately and it’s starting to look good. 3.89% ain’t bad at all!

    Reply to this comment
  20. NIRMAL

    Aug 02. 2011

    Your comments please for YLO.This
    stock is picked by respected BNN stock
    picker ROSS HEALEY.
    It is also picked by Newsletter MONEY REPORTER.
    Thanks

    Reply to this comment
  21. The Dividend Ninja

    Aug 02. 2011

    Nirmal, thanx for posting. It doesn’t matter if they cut the dividend this week or not, they don’t have a solid business plan.

    I already responded to your inquiry about YLO in a different post. You can read it here:

    http://www.dividendninja.com/high-yield-canadian-stocks-part-1#comment-1011

    Reply to this comment
  22. This has to be one of the most thorough articles I’ve ever read about the dividend payout ratio!

    Typically, I use the 60% rule, where I avoid buying into stocks that have a DPR over 60% as I believe that a company in general will do better in the long run with more retained earnings than I can do with the extra money they give me.

    Like all good rules, I’ll make exceptions for some companies assuming they have an excellent track record, and they’ve been around long enough to trust they know what they are doing with such ratios.

    If a company is paying out 100% dividends, that’s like them saying “we don’t know what to do with this! Take it and see how things work out for you.”

    The dividend payout ratio is an excellent indicator as to what a company is up to. A healthy DPR will put some money in a shareholders pocket, while properly funding the growth of the company.

    Thanks for the awesome article,
    Timothy

    Reply to this comment

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