Why I Don’t Give a Crap About the Dividend Payout Ratio

Hoo boy. This is going to be fun.

Right?

Even though this blog has been around for quite a while, I realize I don’t have that many regular followers. I’m working on it though.

That means there is a good chance that not many people will read this, and it will wither away into the ether, nothing more than a whackadoodle’s rant lost forever in the vast expanse of the innerwebs.

But maybe it is a hot enough of a topic within the DGI blogosphere that we can generate a little bit of buzz?

Hear me out…and share the link…and join the discussion by adding your comments. Please? This is supposed to fun.

I realize that the dividend payout ratio is holy canon in the Church of DGI. After all, how else do we know if a dividend is “safe”? Or if there’s “room for it to grow”?

But I have come to question how useful this metric is as a function of evaluating dividend safety and future growth potential.

Now full disclosure: I use the payout ratio too. It’s the first quantitative metric I calculate when working up an investment thesis.

But since I came up with that thesis process, I have found other more rigorous ways to evaluate the safety of a dividend, and I value them a lot more than the payout ratio.

I think it at least deserves further discussion. So here we go.

Payout Ratio Defined

Before I go into the issues I have with the payout ratio, let’s make sure we’re talking about the same thing. Maybe you have a different definition, but most everyone agrees that the dividend payout ratio = dividends paid/net income.

Problem #1 – A Ratio of What to What?

First of all there are all kinds of ways you could express this ratio using totally different numerators and denominators. A strict interpretation of the formula would call for taking total dividends paid from the cash flow statement and dividing by total net income from the income statement.

But no one does that, because 1) looking up the financial statements is kind of cumbersome, and 2) it’s obviously silly to divide things from different financial statements (see issue #2 below).

Dividends and income are conveniently displayed everywhere in “per share” values. So you can divide the dividend per share by earnings per share (EPS) and get the same number…right?

Well…which dividend per share? Are we talking about the trailing twelve months (TTM) of dividends that HAVE BEEN paid or the forward annual dividends that WILL BE paid? What about preferred shares?

For that matter which EPS are we using? TTM? “Forward” earnings? Do you believe the analysts’ projections? Can/should we use the non-GAAP, “adjusted” earnings that companies are so fond of reporting these days?

What about REITs? Common REIT wisdom suggests to ignore earnings altogether because of all the property depreciation and use funds from operations (FFO or their “adjusted” cousin AFFO).

I read so many stock evaluations that will just throw out a statement like, “the dividend payout ratio is X% so the dividend is pretty safe and has room to grow”…but there’s no discussion of what “version” of the ratio we’re even talking about, much less if that actually indicates a safe dividend that truly has room to grow.

Problem #2 – Profit is Imaginary, Cash Flow is Fact

Look, I get it. Companies can’t pay a dividend if they’re not making any money. So evaluating the size of the dividend payment in the context of how much money the company is making is pretty smart.

I’m not suggesting that we shouldn’t consider the safety of a dividend in this context. I’m suggesting that dividing by the EARNINGS is silly.

Earnings are a pretty abstract measure of profitability. There are all kinds of weird accounting things that may get included or excluded from earnings. The income statement is vulnerable to much more gamesmanship than the cash flow statement.

Besides…dividends don’t get paid out of earnings; they’re paid in CASH MONEY. You can show phenomenal paper profits but still not have any cash in the bank (lagging accounts receivables, heavy capex spending, etc).

If you want to evaluate the “safety” of a dividend payment, it makes much more sense to me to at least divide by the free cash flow (FCF) rather than the earnings.

Problem #3 – Creditors Get Paid Before Shareholders

I may feel a lot more confident in a payout ratio that divides by FCF rather than EPS, but even that doesn’t describe the whole dividend safety picture, because it doesn’t speak to the company’s debt situation.

Debt is negative cash. Since dividends are paid in cash, their safety is affected by debt. Period.

If a company faces a cash crunch, and their debt is due, you know that the bondholders are going to get paid first. The dividend will become a secondary priority and might risk getting cut. Maybe they can refinance and kick the can down the road for a while, but eventually there will be a reckoning.

A company’s ability to maintain (or even grow) a dividend through hard times is going to be affected by the health of its balance sheet regardless of whatever payout ratio you use, so any dividend safety discussion really needs to include a conversation about debt.

Solution: The Dividend Cushion Ratio

So how should we evaluate the safety of a dividend? Based on the discussion above, a comprehensive review should incorporate 1) cash flow and 2) debt into the consideration.

Enter the Dividend Cushion Ratio, which elegantly considers both.

Full disclosure: I didn’t invent this. The good people at Valuentum did, and they publish their formula and reasoning for the whole innerwebs to read, so the concept at least is in the public domain.

They offer a subscription based service where their experts calculate the dividend cushion ratio for you based on their expert opinions about future cash flows (as opposed to my dumb version that makes a bunch of dumb assumptions). Also they incorporate momentum analysis into their recommendations.

I’m not a subscriber, and that’s not an affiliate link. I just really like the concept and have incorporated it into my investment thesis process.

Calculating the Ratio

You can read all about the formula, the reasoning behind it and the different elements from the people who invented this ratio here.

Or you can follow along with me today.

Here’s a basic summary of the formula:

Dividend Cushion Ratio = (Net Cash Position + Sum of the next 5yrs of FCF) / (Sum of the next 5yrs of dividend payments)

A value of 1.0 or better indicates a “safe” dividend, i.e. over the next five years the company will have generated as much or more excess cash than it’s going to pay out in dividends.

Less than 1.0 is a cause for concern (where will the cash come from?), and a negative value is just bad juju.

Let’s walk through each of those formula elements and why they mean so much in terms of dividend safety.

Step 1: Calculate Net Cash Position

This is pretty simple, but it’s critical, because this is where we account for the company’s debt situation.

Total Cash – Total Debt = Net Cash Position

While a negative net cash position doesn’t cause an automatic fail (you can make up for it with strong FCF), it’s pretty nice when this starts out as a positive.

A healthy balance sheet is the first step to a healthy dividend.

Step 2: Calculate the sum of the next 5 years of FCF

This is a little more complicated. My crystal ball is perpetually cloudy so I’m hesitant to “project” anything. Like I said, a Valuentum subscription comes with someone’s “expert” opinion of what FCF will be over the next 5 years.

I prefer to just multiply the TTM value by 5, i.e. leave it flat for the next 5 years. A healthy company should be growing its cash flow, so this is theoretically a conservative scenario.

If the ratio comes out greater than 1.0, you can always back calculate how much of a drop the TTM cash flow could absorb and still cover the future payments. Kind of a cushion of the cushion if you will.

Another slight difference between “my version” of the formula and Valuentum’s version is that I like to look at FCF as a function of cash provided by operations less TOTAL cash used for investing.

The GAAP definition of FCF is cash from operations less capex spending, which is only a portion of the total “cash used for investing” line from the cash flow statement. Often these are the same because most of the cash used for investing is going towards capex, but sometimes it’s different.

One reason it might be different is that a company could spend very little on capex and elect instead to acquire whole companies. Or they could have sold some assets or whatever.

It’s a little hand wavy, but sometimes I’ll use GAAP FCF if there appear to be one-off line items in the cash used for investing section. Otherwise I’ll just use the net cash generated value.

I’ll also look at the last five years to see that whatever number I do go with is at least somewhat consistent with historical patterns.

Step 3: Calculate the sum of the next 5 years of dividend payments

This is much simpler to calculate. Rather than assume the dividend is going to be flat, I assume it’s going to grow (I’m a dividend growth investor after all). I apply the market implied DGR to the TTM total cash dividends paid (compounded over 5 years).

So if the company paid $100M (TTM) in dividends and it’s currently yielding 3%, we compound the dividend growth at 7% per year for 5 years: (100*1.07)+(107*1.07)+(114.49*1.07)…etc.

Step 4: Calculate the “Cushion”

Again that’s (Net Cash + 5 years of “generated cash”)/(5 years of cash dividends)

When calculated this way, a dividend cushion ratio of 1.0 or better implies that the company can pay off ALL OF ITS DEBT in 5 years, and still grow the dividend while free cash flow generated remains completely flat.

I think that is a pretty darn safe dividend.

You would be surprised how often a company has a “high” payout ratio (even in terms of FCF) and still has a healthy dividend cushion ratio because of a strong net cash position.

The corollary, which is much scarier to me, is the company that has an allegedly “healthy” payout ratio in terms of dividend/EPS, but due to either goofy income statement shenanigans, weak cash flow generation, or a bloated balance sheet (maybe all three), it doesn’t really have that “safe” of a dividend.

Take Lithia Motors Inc. for example (ticker: LAD). At the the time of writing, this is a dividend challenger sporting 8 years of increasing payments, the 1, 3 and 5 year dividend growth rates are in the high 20% range. The forward annual dividend is $1.08/share against a TTM EPS of $8.19, which is good for a ~13% dividend payout ratio.

Sounds like a solid dividend stock right?

Well the company has $2.4B in debt, $30M in cash, and only generated $100M in FCF in the trailing twelve months. At that rate, it would take 24 years just to pay off their current debt with FCF generated…and that represents the best FCF year they’ve had in the last 5 years.

The dividend cushion ratio (calculated according to the catfishwizard standard) is -11.

Sorry, but a 12% payout ratio implies a much safer dividend than the reality of the company’s financial situation (which is actually pretty ugly).

The point is, it can be a very misleading metric, and that’s why I don’t give a crap about the dividend payout ratio.

Thoughts?

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6 thoughts on “Why I Don’t Give a Crap About the Dividend Payout Ratio

  1. I think that is the whole point of the DGI community, to think differently. Everyone has/ brings different knowledge and skills to the game to share with others. Like you mentioned, the accounting world is cloudy. These days, companies can basically make their financial statements say anything they want. So nothing is certain. That is why everything is an “estimate” or just an “analysis” not a guarantee. Wither it be doing calculations with numbers from different financial statements, or trying to predict future earnings/ revenue/ cash flow/ new debt. There is really no best practice and everyone also has different risk tolerances to invest on whatever they want, how they want. But I do agree, cash is king. I feel much better when a company has a stock pile of cash just in case. That is one of the reasons probably that AAPL is so popular. Thanks for sharing this theory.

    1. Hey DD, I appreciate the comment.

      You’re right there are so many different reasonable ways to evaluate stocks, it’s silly to pretend that one is “the best”…or even distinctly “better” than another. Especially considering the personal aspects of risk tolerance etc.

  2. I think any serious long-term DGI investor knows that looking at payout ratio alone is not enough to determine the safety of a dividend. When it comes to dividend safety I look at cash flow more than earnings. I also pay attention to net cash available and cash flows (both operating and FCF), interest expense, debt maturity, credit rating, and management’s commitment to paying and growing a dividend.

    When I read quarterly reports, I search for “cash flow” and “dividend” to see what the management is saying about these two items and if there is any suspicion or doubt on health of these two items, for example when management tries really hard to convince analysts that dividend is safe, or when analysts start to question company’s ability to pay a dividend, I take those signs as warning signs.

    In any case, nice write-up and a good reminder that payout ratio alone is not sufficient to determine safety of a dividend.

    1. Hi Mr. ATM,
      Thanks for visiting and commenting.

      Credit rating is another good thing to keep a close eye on. I’ve seen so many dividend cuts come as a result of management needing to preserve their credit rating to keep borrowing costs low. That seems to especially effect the heavy leverage business models like REITs and MLPs

  3. Interesting post. I’m still just learning and so I don’t have tons of experience with valuations of companies. There are so many different ways to try and analyze whether or not a company pays a safe dividend and can sustain its dividend over the long haul that sometimes it makes it hard to know where a beginner should start.

    My method is less math intensive. I rely on history and my own understanding of the company. So, if a company has previously paid and increased its dividends for the past 25 years, they are likely to keep doing so in the future. Then I make sure that I at least understand the company before I invest in them. Now, I do realize that past performance is no guarantee of future results and that with new technology, and threats from competitors such as Amazon, that how the company is doing today and their ability to compete in the future are what really matters. But, it says something if a company can weather the great recession we recently had, or any of the other economic or political turmoil in recent history, and didn’t cut dividends.

    So, I don’t pay attention to payout ratios either, but for totally different reasons. Definitely not the best approach I know. And I certainly don’t recommend it. But you did ask for our thoughts and there you have mine.

    1. I did ask for thoughts! I appreciate the comment and participation.

      I think looking at the dividend history is crucial. Generally speaking, companies with a history of paying a growing dividend are more likely to continue that pattern provided they’re in a situation of financial strength to do so.

      I agree that it can be very difficult to know where to start in terms of how to evaluate individual stocks.

      Fortunately there is a lot of material out there. Keep an open mind, absorb as much information as you possibly can and read, read, read!

      You’ll get the hang of it soon enough. s

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