What is the best and fastest way to determine the ability of a company to pay dividend? The dividend payout ratio, right? Most investors would agree. However, it’s a little more complicated. Today, we’re going to review four types of dividend payout ratios along with their pros and cons.
1. The Classic Dividend Payout Ratio
What is it?
The classic dividend payout ratio is calculated by using the dividend per share divided by earnings per share. This classic method will show you how much the company make in profit and the percentage of dividend that is being distributed from those profit.
What’s interesting with the classic dividend payout ratio is the past five or ten years. Then, you can look at the trend. Some companies will maintain their payout ratio in the 50% or 60%. Some others will be more cyclical, like it is the case in the industrial sector. A company like 3M – a dividend king with over 50 years of consecutive dividend increases – has payout ratios going from 35% to 60%, sometimes even 70-75%, depending if they are hit by a recession or not. The trend will tell you more about a company’s stability or if you should dig more to understand why there are irregularities.
The main problem with this payout ratio is earnings per share are calculated using general accounting rules. Any modification to a company’s profits – writing off some assets; making an impermanence; a restructuration special charge; etc. – will affect its earnings. However, it has no impact on its ability to pay the dividend.
A simple analogy would be buying a house at $400,000. Three years later, the housing market is down, we’re in the middle of a recession. You call a real estate agent and ask to put your house on sale. He would reply: “Sure, but you paid 400,000, and today the best you could sell it is at 360,000 as it is the price on the market today”. On your balance sheet, you’re losing $40,000 in assets in your net worth, but it doesn’t affect your ability to pay your mortgage.
It’s the same thing with the payout ratio.
2. The Cash Payout Ratio
What is it?
If I had to choose between the dividend payout ratio and the cash payout ratio, I’d use the cash payout ratio as it is telling me the ability of the company to use cash flow to pay dividends. Basically, it’s the cash in their bank account. To calculate it, we use the dividend paid divided by cash flow from operations.
That means whatever the business generates in money minus capital expenditure (known as CapEx) and preferred dividend paid. That way, you see how much the business is generating in cash flow minus all the investment that is being used (R&D, innovation, acquisition, any kind of projects that will make the company grow in the future).
Having large CapEx is a good thing because it means management has growth vectors and they want to build a better business over the long run. The problem is when you look at the cash payout ratio and you have an important capital expenditure. For example, a major acquisition or building another factory (project with billions implied) could result in a high cash payout ratio or even a negative cash payout ratio. Therefore, you may think that the company might cut its dividend while in fact most projects are being financed through debts or the issue of more units or more shares (depending if it’s a REIT or a company).
Whenever you see a high or negative cash payout ratio, you must dig into their quarterly earnings and analyze what the project looks like; if it’s going to increase their debt, and if they will be able to pay their dividend with their cash flow and finance their CapEx with more debt or more shares.
Obviously, dividend payout ratio and cash payout ratio are used for classic companies – Starbucks, Microsoft, Coca-Cola or Procter & Gamble – businesses that have regular revenues and earnings. You might get weird results for more complicated companies like pipelines and utilities that are capital-intensive.
3. Distributable Cash Flow Payout Ratio
What is it?
In those cases, the company itself will likely use distributable cash flow payout ratio. Calculation is the dividend per share divided by the distributable cash flow per share.
The distributable cash flow payout ratio gives you a very clear picture of the ability of the company to pay. The best example could be Enbridge (ENB), which currently has ridiculous payout and cash payout ratios (around 300%). However, its DCF payout ratio is around 65%. Suddenly, the yield and the dividend growth rate both make sense.
The problem with this one is the fact that it’s almost impossible to get from any financial website. It’s basically a number that is being calculated by the company itself. You have to go into their quarterly earnings report, and then look at how they calculate it. Usually, companies have a full slide explaining in detail how they reach that distributable cash flow and how they made those calculations. Therefore, it’s clear but it requires a lot more time.
Also, if you want the 5 or 10-year trend, you’ll have to rely on the business generosity of making those draft… or go back into all the annual statements; take down notes and use an Excel spreadsheet. That’s some monk’s work that most of us are not motivated to do!
4. Funds From Operations (FFO) or Adjusted Funds From Operations (AFFO)
What is it?
If you are a retiree, one of favorite types of stock is probably REITs since there are very stable and usually offer a higher yield. The FFO and AFFO are being calculated by the REIT and is usually provided in a detailed way.
Because of REITs’ tax structure, they are required to distribute at least 90% of their profit. Using payout ratio and cash payout ratio would not be of any use. This is why you should look at funds from operations (FFO) and adjusted funds from operations (AFFO).
It’s very important that you look at the number per share or per unit, instead of looking at the overall funds from operation trend. A lot of REITs in the past 10 years have grown by acquiring new properties or by renovating to increase their revenue. Basically, they increased their funds from operation by issuing more units. The more units they issue, the more money they have to grow or to pay in dividends.
As an example, let’s say they first had 1000 units and paid $1 in dividend per year. The first year, it costs $1000 in dividend. The next year, they decided to issue 200 units, going up to 1200 units. You guessed it, if they still pay $1 per unit, they’ll have to pay 1200 bucks. This is why you need to look at numbers per share.
If a REIT was not able to increase it over the past five years, it will likely hit a big road bump with the recession. Those are the REITs that are more likely to cut their dividend or stop increasing them.
In other words, a REIT paying a 7% yield is usually a red flag. You have to go a little further and look at the FFO payout ratio. If it’s over 100% for more than 3-4 quarters, it should ring a bell. Chances are that next time they have a problem, they will have to cut their dividend.
How to see a dividend cut coming?
Usually, the market is pretty smart and sees dividend cutters coming. They start selling the stock. You’ll see the shares price going down; the yield is up; the payout ratio is through the roof… and then you get the dividend cut. This is why you should follow the trends instead of simple numbers. Make sure that you understand the context behind the numbers and how it has been calculated. This way, you will be able to avoid a lot of dividend cuts. I went deeper in the topic and gave more tricks to avoid dividend cuts in my Payout Ratios Webinar. You can still register to watch the replay.