The Dividend Payout Ratio Is The Holy Grail Of Dividend Growth Investing
Jun. 23, 2015 12:24 PM
- The traditional dividend growth approach of looking at historical dividend payments is flawed.
- Focusing on the dividend payout ratio provides a better warning of dividend cuts.
- High dividend but low payout stocks can lead to outperformance as well.
The holy grail of dividend investing is finding companies that can reliably increase their dividends year in and year out like clockwork. Stocks with increasing dividends are not only important to retired investors looking for a growing income stream but are also important to investors looking for growth of capital, as dividends provide a hefty portion of the total return of stocks. Indeed, there are many funds and indexes that seek to invest in these types of dividend growth stocks.
Standard & Poor's (a division of McGraw-Hill) maintains a list of dividend paying stocks called the S&P 500 Dividend Aristocrats. It is an unmanaged index composed of every company in the S&P 500 that has increased its dividend for the last 25 consecutive years. Each company is given equal weight in the index. There is also an alternate version called the S&P High Yield Dividend Aristocrats Index which contains only the 50 highest yielding stocks that have increased their dividends for the last 25 consecutive years. Other companies have their own versions of dividend growth indexes such as the NASDAQ US Dividend Achievers Select Index which is composed of companies that have paid annual increasing dividends for at least 10 years. Many popular mutual funds and ETFs have sprung up which follow these indexes such as the Vanguard Dividend Appreciation Index Fund (MUTF:VDAIX ) or the SPDR Dividend ETF (NYSEARCA:SDY ).
While this methodology for selecting dividend stocks may sound good on the surface, there is one glaring flaw in both the indexes
and by extension the funds that follow them. The methodology only looks backwards and assumes the future will be the same as the past. The index makes no attempt to look at the company's current financial situation and determine whether it is likely to continue paying dividends in the future, a critical oversight.
Investors should focus on a stock's payout ratio, not dividend history when assessing suitability as a dividend growth stock.
Look to the Payout Ratio Not Dividend History
A stock's payout ratio refers to the proportion of net income the company pays out as dividends. The payout ratio tells you how much of a company's income is being paid out as dividends and how much is left over to fund expansion of the business, acquisitions, share buybacks, or to stash away for a rainy day.
The payout ratio can be used to weed out companies whose dividends are safe, whose dividend are in jeopardy, and who have room to increase their dividend. In competitive market based economies, all companies will have struggles from time to time. It's important for investors to know when to throw in the towel and when issues are either transient or fixable and a company's dividend is safe. The payout ratio can answer this question.
Compared to a company's dividend history, the payout ratio has much more predictive power and tells us a lot more about the financial health of a company. Take for instance the case of Pitney Bowes Inc. (NYSE:PBI ). a former member of the S&P 500 Dividend Aristocrats. By looking at the payout ratio rather than the company's dividend history, investors should have been able to spot problems with Pitney Bowes before the dividend cut came.
The table below shows Pitney Bowes' revenue and dividend payout ratio over the past decade. I've highlighted 2013 which was the year the dividend was cut.