In my dividend-oriented Yield Hog column, I often mention a company's payout ratio.
Today, in response to reader questions, I'll explore the concept in greater detail.
What is a payout ratio anyway?
A payout ratio indicates what percentage of a company's profits are being paid out in dividends. Generally, the lower the payout ratio, the safer the dividend and the more room for dividend increases.
The most common method of calculating a payout ratio is to divide the company's annual dividends per share by its earnings per share. For example, Coca-Cola reported earnings per share of $1.90 (U.S.) in 2013 and paid dividends of $1.12. Its payout ratio was therefore $1.12 divided by $1.90, or 59 per cent. This is what's known as the trailing 12-month payout ratio.
A payout ratio can also be forward-looking: Coca-Cola has since raised its dividend to $1.22 annually, and analysts expect the soft-drink maker to post earnings per share of $2.10 in 2014, so its projected payout ratio this year is 58 per cent.
What is an acceptable payout ratio?
It depends on the company, industry and other factors. A mature business with relatively stable earnings and modest growth ambitions will typically pay out a greater percentage of earnings than a young company that needs to reinvest most of its earnings to expand.
For example, electric and gas utility Fortis had a payout ratio of 72 per cent in 2013, whereas fast-growing discount retailer Dollarama's payout ratio was 16 per cent in its most recent fiscal year.
Some companies set a target range for their payout ratio. This provides greater transparency to investors and helps the company balance the desire to reward shareholders with the need to reinvest in the business.
For example, Bank of Montreal's policy is to pay out 40 to 50 per cent of its earnings as dividends. Enbridge aims to pay out 60 to 70 per cent of earnings. And Telus's target is 65 to 75 per cent of "sustainable net earnings."
Companies might stray from their targets temporarily – say when earnings take a one-time hit – but they generally try to stay within the goalposts.
Can a payout ratio exceed 100 per cent?
Yes. If a company's earnings are tumbling, it can find itself dishing out more in dividends than it makes in profit. To make up the difference, it can borrow money, sell assets or use the cash on its balance sheet. Eventually, however, it may have to cut the dividend.
In some cases, though, a payout ratio can remain above 100 per cent for an extended
period.
How? Well, earnings include accounting items such as depreciation and amortization that don't affect the actual cash generated by the business. So a company could have more than enough cash flow to cover its dividend even though its payout ratio exceeds 100 per cent of earnings. For that reason, analysts will often use cash flow, or free cash flow (which deducts capital expenditures), to get a truer picture of the dividend's sustainability.
How do I calculate a REIT's payout ratio?
Real estate investment trusts typically report their payout ratios as a percentage of specific cash flow measures – namely funds from operations (FFO) and adjusted funds from operations (AFFO). You can usually find these numbers in a REIT's financial statements.
The actual definitions are complex, but FFO is essentially operating profit excluding depreciation and any gains or losses on the sale of properties. AFFO – a stricter measure of cash flow – is basically FFO less maintenance capital expenditures and leasing costs, to reflect the cash a REIT spends to maintain its buildings.
REITs are structured to pay out most of their cash flow as distributions. As an example, RioCan – Canada's biggest REIT – had an FFO payout ratio of 86.5 per cent and an AFFO payout ratio of 95.3 per cent in 2013.
Final thoughts
Because there is no simple rule of thumb with payout ratios, it's important to read company websites and financial reports to familiarize yourself with their dividend policies. If you stick with companies that have a manageable payout ratio – and whose sales and earnings are growing – you'll increase your chances of getting rewarded with dividend increases and avoiding the pain of a dividend cut.
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John Heinzl