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Payout ratio: A key clue to dividend sustainability Add to ...

What is an appropriate dividend payout ratio? And where can I find this information?

It would be nice if there was a magic number for the dividend payout ratio, but it’s not that simple. Payout ratios vary depending on the industry and the company’s stage of growth. What’s more, the ratio itself can be calculated in different ways.

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Understanding this ratio is important, because it can provide clues as to the sustainability of a company’s dividend and the potential for it to grow.

Typically, the payout ratio refers to the percentage of a company’s earnings that are paid out as dividends. However, the ratio is also sometimes expressed as a percentage of cash flow, which excludes non-cash items such as depreciation.

Young, fast-growing companies tend to pay out little or nothing in the way of dividends, because they need to reinvest cash in the business. Cyclical companies with volatile earnings – materials producers, for example – also tend to have very low payout ratios, because they can’t sustain a high dividend in bad times.

At the other end of the scale are mature companies whose predictable earnings and strong cash flows allow them to pay out a higher percentage of their profits. Examples include utilities, pipelines and telecoms.

Some companies set a target range for their payout ratios. Telecommunications provider Telus Corp., for example, aims to pay out 65 to 75 per cent of “sustainable” earnings. Pipeline operator Enbridge Inc. pays out 60 to 70 per cent, which it says provides “a healthy balance between returning income to shareholders and retaining income for re-investment in new growth opportunities.”

As an investor, I like to see a target payout ratio, because it’s a sign of financial discipline.

Real estate investment trusts (REITs) are structured, for tax reasons, to distribute most of their cash to unit holders. As a result, they have even higher payout ratios, generally ranging from 75 to 95 per cent.

In extreme cases, a payout ratio can exceed 100 per cent. How is this possible? Well, a company can dip into its cash resources or borrow to sustain the dividend even when its profits take a hit. Also, if a company has a dividend reinvestment plan, or DRIP, it can pay out more than it earns because many investors choose to take their dividends in shares instead of cash.

But a company can’t pay out more than 100 per cent forever. Eventually, it will either have to cut its dividend, or increase its profits. In such situations, the company should have a plan for addressing the shortfall.

Case in point: For several years, RioCan REIT paid out more than 100 per cent of its adjusted funds from operations, or AFFO – essentially the real estate equivalent of profit. But as RioCan’s AFFO has grown with property acquisitions and developments, the payout ratio has fallen. In the first quarter, it was about 95 per cent, and RioCan plans to reduce it further even as it aims to increase its distribution by about 2 to 3 per cent annually. (In December, RioCan raised its distribution by 2.2 per cent – the first increase since 2008.)

If a company has a very high payout ratio and unpredictable earnings, however, that can be a red flag. For example, struggling mutual fund company AGF Management Ltd. paid out 85 per cent of its free cash flow in the first quarter and 106 per cent in the fourth quarter. The stock is yielding 9.3 per cent, indicating that some investors expect a dividend cut.

You can find payout ratios on Globeinvestor.com by setting up a watchlist of stocks and choosing the “dividends” view. (Note: Globeinvestor uses trailing 12-month cash flow in its calculation.) You can also look up historical dividend and earnings data on the company’s website and do the calculations yourself. This method is more labour intensive, but it has the advantage of giving you the ratio over several years, rather than in a single year when earnings may have been distorted by a one-time event.

Also be sure to read a company’s quarterly earnings reports and transcripts of conference calls, which often include information about the company’s dividend policy.

There are no simple rules of thumb with payout ratios. But if you stick with strong companies that have manageable payout ratios – and which also have growing revenues and earnings – you’re more likely to be rewarded with dividend increases and less likely to suffer a dividend cut.

 
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