Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
Growth, Value, and The Future
If you're interested in passive income, odds are pretty good that you've investigated dividend growth investing, one major cornerstone of a good income or retirement strategy. While most investors appreciate the need to buy their stocks at a low price relative to their intrinsic value, and nearly everyone focuses on yield, there's a more subtle metric that's at least as important in order to help you understand the future cash flows of a company: the dividend payout ratio. If you can wrap your brain around what this measure means for the health of the business, you can make a much more informed decision about whether a stock is a buy or a sell today. Let's dive right in.
The Magical Money Printer
If a friend of yours had a magical money printer they wanted to sell to you, you'd rightfully have some pretty good questions to ask before you told them what you'd be willing to pay for such a device. One question would surely be how frequently the money is printed, and how much is printed. If the money printer is a good enough analogy for a stock that pays a dividend, then the frequency and "how much money" questions here refer to the dividend yield, and whether the business pays out semiannually, quarterly, or monthly. Another question you'd have about the printer is whether cash can be printed forever, or if there's a shelf life on printing cash. If you're valuing a stock, you might rightly equate this concept with a terminal value. The final question you might ask, as a thoughtful prospective investor in the money-printing business, is whether you might have to spend money in order to keep the printer running. Do you need to supply the ink or paper? What about regular maintenance? Do you need to replace parts over time? Here's where a dividend payout ratio can be a useful proxy for determining the future value of the business, and a great lead-in for a way for us to understand it better.
All Else Equal
When a good business brings in money through cash flows, they're faced with a choice as to what to do with that money. By now, the idea of snowballing is probably completely natural for you, and understanding that compounding returns allow an ever-growing principal, as interest (or dividends) are reinvested back into the original business. Clearly, if you've bought a stock, you believe that purchasing that stock is a better option than just leaving your money on the sidelines, and if it's a better investment than you can find elsewhere, you'd want for the business to reinvest your returns in itself, all else being equal (and assuming you don't need the cash right now). Adding to this phenomenon is the complexity of the US tax code, and the fact that if a company pays a dividend, you have to pay taxes on that dividend immediately, that year; whereas if a company doesn't pay anything out, you would only owe taxes if and when you sell the stock itself. This means that, all else being equal, a business that reinvests more of its free cash into itself is better. Of course, all else isn't necessarily equal, and there are some interesting caveats worth discussing.
As a business owner, I learned some tough lessons first-hand over the years. One was understanding the difference between cash flow (the amount of money flowing into or out of your business over a period of time) and net income (the accounting profit or loss for your business). In short, cash is king, and while net profit is a very important metric to pay attention to over time, you need to be sure you have money to pay your bills (and yourselves, depending on how far along your business is). I couldn't understand how we kept having an accounting profit, but kept on being broke! It turns out that reinvesting in the business, typically called a capital expenditure, is accounted for very differently than cash, and understanding that this capex would mean potential long term returns, but no cash this year, was the piece of the puzzle I was missing. In an ideal world, the more you reinvest back into the original business, the better.... so 0% must be the ideal dividend payout ratio, right? Well.... not so fast.
Businesses are complex entities, and not all capital will be reinvested into the same things. Clearly, this is going to vary a lot across a wide range of industries and even within individual businesses, but it's pretty safe to assume that not every dollar will be spent the same way. Maybe the first 10% of cash returns 100% over the next year, but then the next 10% doesn't add any value at all to the company. This is why management matters so much; a good allocator of capital will know roughly where that line should be drawn so that shareholders are taken care of.
There are also some company-specific legal requirements and reasons why some sectors might pay out a lot more than others. REITs (Real Estate Investment Trusts) actually require the managers to pay out around 90% of their net income, leaving very little to reinvest in additional real estate. Utilities pay out a lot more since their line of business typically presents fewer buying opportunities, and many retired folks have a healthy concentration of utility companies that pay out a solid dividend each month or quarter. A service oriented software company, on the other hand, may need to reinvest all its cash now so that the product that delivers the service can be created and maintained, but after a few years, this early reinvestment could pay off in a much higher payout ratio as the company matures.
Can the answer really be: "it depends"? While the industry and future business opportunities for the company will help to inform what a good payout ratio should be, the metric is really just another filter to run a company through, so you can determine whether they're doing a good job of running their business, and what you can expect in returns over time. However, you can also put some useful guidelines based on industry norms and expectations, and those can help you to do your analysis more carefully. As a baseline, somewhere between 35% and 60% makes a good starting point for the market. If a company is paying out less than 35%, they probably think pretty highly of their current growth opportunities. On the other hand, if a company is paying out much more than 60%, it's worth considering whether that payout is sustainable. If it's not, they'll either have to lower the dividend (not generally good for share prices), sell more shares (not great for your ownership stake), or take out some additional debt in order to keep paying (debt can be incredibly dangerous). Remember that a younger tech company is likely to pay zero or a very low dividend, since the perceived prospects for growth are very high; and keep in mind that a much more mature company in an industry that doesn't require a lot of capex might be a much higher payout ratio. Neither of these is right or wrong in and of themselves, but both can help to provide a better understanding of the company so you can make a more informed investment decision.
Lasantha Wijesekera from Sri Lanka on July 05, 2021:
Very useful article. Thanks for sharing.