In Part I (link) we explored the question “is a higher yield always better?” Not necessarily it turned out if it’s only the result of a declining stock price. Now let’s break down the dividend yield further by zooming in on the annual dividend payout. As a future investor you must ask: Is the dividend sustainable?
Back to fictional company Best Coffee that is currently trading at $15.00 per share. With declared annual dividends at $1.00 per share, the dividend yield is 6.7%. Not too shabby but does it mean Best Coffee’s a good investment?
As a potential Best Coffee investor you look beyond today’s dividend amount to measure it in context. Is the amount reasonable and, more vital, can it be sustained? One key financial metric to watch is the payout ratio, which means the proportion of earnings (or cash flow) paid out as dividends to shareholders. The payout ratio helps determine the sustainability of a company’s dividend payment.
Best Coffee has expected annual earnings of $1.10 per share and pays a $1.00 per share dividend. Its 90% dividend payout ratio may or may not be fine so let’s dig deeper. What if Best Coffee has plans for aggressive store expansion; paying out such a large portion of its operating earnings to shareholders may be inconsistent with its business strategy. Will it issue shares or borrow to fund future growth? If earnings become depressed, due to some temporary macroeconomic or business-specific factors, is the dividend cut? What happens to the share price if the dividend gets cut? That last question is facetious and pretty easy to answer. The stock price drops precipitously, and instantly.
The dividend that Best Coffee pays is a distribution of its operating earnings. As a shareholder this seems attractive but is it the best use of profits? Operating earnings can fund dividends, retire debt, repurchase shares or stay within the company as retained earnings. Essentially every dollar paid out as a dividend is one that won’t be reinvested in growing the business or used to improve the corporate balance sheet. As a shareholder dividends are attractive yes, but not at the cost of future growth or financial stability.
A last touchstone is to compare Best Coffee’s payout ratio to others in the same industry. If Best Coffee’s payout ratio is substantially different than say Second Choice Coffee then puzzle why that is? Sometimes management takes liberties by adjusting earnings or substituting another proxy. Make sure you are comparing apples with apples. All things being equal a lower payout ratio is generally preferable to a higher payout ratio.
So in the end it’s not the size of the dividend that truly matters rather the fundamental strength of a business. Sustainable dividend payers must at the same time be great companies able to grow earnings — in all kinds of environments.