Dividends – The Importance Of The Payout Ratio
I love nothing more than getting cold hard cash from my investments. I love to see my bank account grow dollar by dollar. Instead of working for my money, I’m making my money work for me.
Is your money pulling its weight?
One of the easiest ways to get your money working for you is to buy dividend paying stocks. Dividends are all over the news right now. You can’t go a single day without hearing the terms “dividend yield” or “payout ratio”. The talking heads on TV are throwing these terms around with abandon. (If you don’t know what these mean, I’ll explain them in a moment.)
Some market prognosticators are even announcing now as the time to buy dividend paying stocks. But there’s a problem. Sometimes a dividend can be deceiving. A dividend might actually be lying to you.
Never buy a stock just for its dividend.
It’s like picking up pennies on the freeway. Sure you’ll make a few bucks, but you risk getting crushed.
Remember, companies are cutting dividends left, right, and center. Just think about all those investors who bought financial stocks expecting big dividend payouts. Most of them have disappeared.
Did you know there’s a way to add some safety to dividend investing?
Let me explain.
Every company who pays a dividend has a payout ratio. The payout ratio is an important number to know. You calculate it simply by dividing the annual dividend by the annual earnings per share.
For example, in 2008 IBM reported earnings per share of $3.28. During 2008, they paid out an annual dividend to shareholders of $1.90. IBM’s payout ratio is 58% ($1.90/$3.28 = 58%). Not bad. Personally, I get a bit nervous if the payout ratio is over 70% for any company.
Why is this number important?
The payout ratio tells us what part of profits are being returned to investors. This ratio is very important to watch. In the past, some companies have had payout ratios over 100%… that means they’re sending more money to shareholders then they’re making. It’s a situation that can’t last for long.
At that point the company has two options… make more money, or cut the dividend.
It doesn’t take a rocket scientist to see that cutting the dividend is usually the only choice. We’re seeing it all the time now, especially in the first quarter of 2009.
As a matter of fact, S&P recently reported on that very topic. For the first time ever, the number of dividend cuts outpaced increases. And, it’s not just banks who are cutting their dividends. We’re seeing it in industrials, technology, and even energy companies.
So, where should we look for good dividend paying stocks?
I have an idea. I’d focus on companies who have recently increased their dividends. If a company is able to increase the amount of money they are returning to investors, it’s got to be a good sign.
It tells us despite the economic slowdown, their business is still successful. It tells us they have the cash flow to support the payout. And it tells us management and the board are confident about the future of the business.
A handful of companies have announced dividend increases. A few include: Procter & Gamble (PG), Southern Co (SO), TJX (TJX), and IBM (IBM). If you want to grab some dividends, I’d start by looking closely at a few of these.
Category: Dividend Stocks
