Years of doing research, reading academic studies and working on portfolios (including mine) brought me to this set of rules that enables me to simplify my investing process.
Principle 3 – Find sustainable Dividend Growth. It is one thing for a company to show growth in the past, but is it able to continue doing so? The payout ratio is a popular metric among investors to determine growth. However, it is important to understand the trend behind the number!
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00:00 Mike Heroux: Hey, fellow investors. This is Mike Heroux from Dividends Stocks Rocks. I hope you’re doing well today. Welcome to part three of the Dividend Growth Investing Principals. During the first video, we have discussed how high yielding stocks may not always equal high returns. And on a second video, we discussed how it is important to focus on dividend growth. For the third part of this seven-part series on dividend growth investing principles, we’re going to tackle a notion that is sometime misunderstood is how to find sustainable dividend growth. Meaning that you might wanna look at companies paying their dividend, some of them has increased it in the past, but you wanna make sure that those dividend will continue to be paid in the future, and most importantly that will continue to grow.
00:52 MH: Most investors will have the reflex of going right away and look at the payout ratio, but actually the first red flag telling that a company may eventually stop their dividend or cut it down a little bit is an absence of growth. So if a company has kept the same dividend payment for a few years, they might be just one step closer to cut it out. So the first thing is look at the dividend trend, and then if you don’t see any growth, that’s a first red flag. It doesn’t mean that you should sell the stock right away, but just see it as an opportunity to investigate a little further.
01:33 MH: Now, if you wanna look at the payout ratio, you must understand that there are several metrics included in that kind of simple data. So basically, the payout ratio is simply the dividend payment divided by the earnings per share. So basically, you’re just looking at the ability of the company to get their profit and distribute it as in form of a dividend. The problem with this metric is that earnings per share is calculated according to accounting principles. It’s not cash in the bank account of the company. So most investors will look then at the cash payout ratio, which is the cash flow that is available from the company to be distributed to shareholders. This will give you a little bit a better understanding if the company is able to continue paying their dividend or not, but then again you must be careful about what is a good payout ratio. In some industries, you’re going to see high payout ratios of like 80%, 90%, even at 100%. And then in others… And other companies may offer you like a 25% or 30% payout ratio.
02:55 MH: So is it better to have a 30% or 90%? The thing is, you wanna make sure that the company keeps increasing it, and if the company has such a low payout ratio like a 20% payout ratio, for example, the chances are that their focus and their priorities are elsewhere than rewarding shareholders with dividend payment. They might need more money to invest in R&D, for example, or they wanna do more acquisitions, or they need their cash flow, because they’re operating in a capital intensive industry. So you wanna make sure that you understand where the money is coming from and where the money is going. So a key metric here is not necessarily to look at a payout ratio of 30%, or 50%, or 100%, but just to look at the trend.
03:49 MH: In a perfect world, what you would like to see is a company that is growing its dividend year after year, but maintaining their cash payout ratio pretty much around the same thing. So, if the cash payout ratio most of the time will be… A good one would be between 50-70%. But from time to times for some reasons, they hit a bad year, and then the payout ratio goes up to 90%, and it’s not a reason to get rid of the stock. It would be a reason if the payout ratio keeps getting higher and higher year after year, and then you see that the dividend growth is slowing down. So a company that is only increasing its dividend by 1% or 2% at one point in time, and it used to be able to do it like mid high single digit, like 5%, 6%, 7%, 8%, now it goes down to 2%, then you can start to worry about it, especially as the payout ratio is higher.
04:46 MH: Now, depending on the type of industry, the cash payout ratio and the payout ratio may not be useful. If you’re looking at REITs for example, then you need to look at the AFFO payout ratio or the FFO payout ratio. So, this is the fund from aspiration or adjusted fund from operation payout ratio. So we’re basically looking at the money that is being generated by properties that is available for distribution for shareholders instead of using the traditional cash payout ratio or the payout ratio. Same thing with business development companies, they’re often called BDCs, now you’re going to look at the net interest income payout ratio. So now you’re looking at how much a company is generating in interest income instead of earnings. And you also have the distributable cash flow per share that is often used for master limited partnerships, so MLPs. So as you can see, it is a simple… It is a simple point of view to just look at how much the company can afford to pay in dividend, but it gets a little bit tricky when you go down in the metrics and then you look at other data altogether. So then again, the classic point is to look at a growing trend for dividend, but a stable one for the payout ratio.
06:16 MH: In order to help you out, because there’s a lot more to cover for payout ratios, I have done two webinars. The first one is called ‘Make Sure That Companies Pay Their Dues’, so pay their dividend. And the second one is ‘Red Flags Telling You it’s a Bad Dividend Stocks’. So those two webinars are free. You can register using the link down below in the description. You’ll get a lot more information about how to read those ratios to understand where it’s coming from, and how to identify red flags that may lead to a potential dividend cut or a bad investment.
06:53 MH: So I hope that you have enjoyed this video. In the next one, we’re going to talk about the dividend triangle. This is something that I’m using a lot for DSR. So I’m gonna tell you how it works in the next video. And until then, stay invested and get those dividend growing. Cheers.