A spendthrift is not a thrifty person. Thrift can be a good thing. It is wisdom and caution regarding the management of money. It involves avoiding waste and saving for the future. A spendthrift, however, is a person who wastes their assets or estate in such a way that they expose themselves or family to suffering and living week-to-week. Laws are in place for trust accounts to prevent a beneficiary or heir from wasting their assets due to immaturity.
A spendthrift company is also one that has a board of directors and management that wants to keep shareholders happy regardless of the long-term costs and implications for the future of the business. Essentially, they spend more than the company earns, but they appear to be generous by giving investors a dividend. They also often neglect reinvesting in the business.
One way to identify or see a caution flag is by examining the company’s dividend payout ratio. This is another basic math calculation.
Why Does this Matter?
Most investors are not happy when their investment goes down in value. They may want income, but they generally don’t want income that comes at the expense of catastrophic declines in the value of their investment. Some day they may want to sell their investment. Therefore, it is best to buy dividend growth company stocks with rational dividends supported by earnings.
What is a Dividend Payout Ratio?
It is how much of a company’s earnings they are giving company owners (stockholders) in the form of a dividend payment. For example, if a company earns a dollar in the first quarter, and they give each investor a dollar in dividends, the payout ratio is 100%. This may be (depending on the type of investment) very reckless.
A more complete definition is: “The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company. It is the percentage of earnings paid to shareholders via dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or to reinvest in core operations. It is sometimes simply referred to as simply the payout ratio.” Source: Investopedia
Some more mature companies are able to give a higher percentage of earnings to their investors. In fact, some types of business are required by law to give most of the earnings to stockholders.
If you invest in real estate investment trusts (REITs) you might be frightened by payout ratios of more than 100%, 200%, or even 300%. However, REITs are unique entities. The better metric for REITs is NFFO, or Net Funds From Operations. For example, Realty Income Corporation (Ticker O) has a dividend payout ratio of 282.45%. If Apple or IBM or Microsoft had a payout ratio greater than 100% you should be very nervous. Of course, these companies won’t even come close to 100% because they are using some of the earnings for growing the business.
How to Calculate Dividend Payout Ratio
Most of the time it is just easier to look up the payout ratio on Fidelity, Seeking Alpha, or another investing website. To calculate the dividend payout ratio, you need to know the total dividends paid to all stockholders and the company’s net income. So, if a company made $100 million, and they paid dividends totaling $50 million, the payout ratio is 50%. This also means the company kept $50 million for various purposes. They might buy back their shares, buy equipment or property, or start a new product line.
When is it Safe to Buy a Dividend Paying Investment?
When you invest in ETFs or mutual funds, there is no “payout ratio.” You are counting on the fund manager to pick rational investments. But if you are buying a stock, you need to know if it is a REIT and then if the dividend payout ratio makes sense for the business sector. The payout ratio for a utility will generally be higher than the payout ratio for a technology or healthcare company. This is usually OK. However, you can have a general rule that helps you avoid a goofy investment.
A General Rule About Dividend Payout Ratios (DPR)
A good general rule of thumb is to look for companies paying growing dividends that have a dividend payout ratio between 20-70%. So, for example, MSFT, IBM, ORCL, and STX all meet that general rule. Apple (AAPL) does not. Apple’s DPR is less than 20%. However, that isn’t necessarily bad unless you want to have investments with more income potential. IBM may have a better payout ratio, but IBM also has a poor ten-year stock price performance. If you bought IBM ten years ago, it has decreased in value by -24%. AAPL, by way of contrast, has grown by 566%.
There are tradeoffs. Those who buy IBM shares receive a 4.68% dividend, while AAPL shareholders only see a 0.66% yield.
When you buy a dividend investment, you should know the dividend yield. But don’t buy on yield without looking at the dividend payout ratio. In fact, the payout ratio is far more important than the yield. However, there is another important factor. Next time I will discuss that factor.