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Ideally, you want to focus on the stocks that are most likely to continue mailing you those dividend checks quarter after quarter and year after year. And better yet, a company with the ability to consistently grow the dividend payout over time.
The most popular measure of dividend reliability is the dividend payout ratio, which is calculated as follows:
But I believe it’s a flawed measure that can too easily mislead investors.
Have you ever wondered how some companies manage to always hit their earnings estimates or even beat that number by just a penny or two every quarter?
It’s because folks in the corporate finance department might be playing games with the numbers. They misclassify some revenues here or move around expenses there. Often, it’s only by a little bit. A small fudge factor that’s hardly noticeable. But they do this to avoid disappointing investor expectations.
And the pressure is even greater on dividend-paying companies. That’s because they have two targets to hit every quarter.
Not only do they have to meet or beat earnings estimates each quarter, but they also must pay the same dividend every quarter — or better yet, increase it.
If a company misses its earnings estimate, Wall Street downgrades the stock, and institutional investors might bail out. And if a company cuts its dividend, income-oriented shareholders who were counting on that dividend will most likely bail too.
The pressure to hit those earnings and dividend targets creates a big temptation to “fudge” the numbers, just a little bit.
That’s why I prefer to use cash flow over EPS when measuring dividends. And as I explained in TradeSmith Daily last week, you can even do one better with the more conservative measure of free cash flow (FCF) on a per-share basis.
The next step is to calculate a more conservative dividend payout ratio by using FCF instead of EPS:
Now back to figuring out how reliable a stock’s dividend really is, and then I’ll give you a side-by-side comparison to illustrate the difference.
Using the traditional formula, a lower dividend payout ratio is generally better. A good range for a reliable payout ratio is anywhere from 30% to 50%. For example, a stock that reports EPS of $1 and pays a $0.50-per-share dividend has a payout ratio of 50%.
Once you start getting well above that level, into the 65% to 70% range or even higher, you have to wonder about the company’s ability to keep paying such a high dividend relative to its profits. Above 100%, a stock’s dividend reliability gets really suspect.
As an example, let’s say ABC Company has a 75% payout ratio. That means it’s paying out $0.75 of every dollar in profits, and it’s only retaining $0.25 of each dollar to reinvest in and grow the business.
There just isn’t much margin for error here.
What if competition from XYZ Inc. heats up and ABC starts losing business? What if ABC has a few bad quarters or a bad year? What happens if the whole economy tanks? ABC will probably have to slash its unsustainably high dividend or eliminate it altogether.
Let’s compare two real companies in the same sector to see which one could provide you a more reliable payout.
Battle of the DividendsThe two companies we’re going to have battle it out today are Williams-Sonoma Inc. (WSM), a home furnishings retailer, and the fashion retailer Gap Inc. (GPS).
WSM has a dividend yield of 1.9%, and GPS has a dividend yield of 5.6%.
On the surface, you might go for GPS. After all, its dividend yield is about three times that of WSM.
But take a quick look before you take the leap of buying GPS based on just the dividend yield.
Because the real question is, how sustainable is that payout?
Let’s find out.
- WSM reported FCF per share of $14.99 in 2021 and paid out dividends of $2.42 per share for the year. That gives WSM a payout ratio of only 16%.
- GPS reported FCF per share of $0.30 in 2021 and paid out dividends of $0.48 per share for the year. That gives GPS a sky-high payout ratio of 160%.
That’s one reason why WSM has not only paid dividends every single year for the past decade but steadily increased them each year, from $0.88 a share in 2012 to $2.42 last year. That’s a 175% increase in dividends per share.
GPS, by contrast, has little or no margin for error. It’s already paying out more in dividends than it earns in free cash flow. That’s simply not sustainable. If business gets worse, GPS will almost certainly cut its dividend payout, or maybe eliminate the dividend completely.
In fact, during the pandemic in 2020, GPS was forced to slash its dividend to $0.24 per share for the year, down 75% from $0.97 the year before. And its annual dividend today is still lower than it was 10 years ago.
Bottom line: Don’t automatically go for stocks with the highest dividend yields without doing some additional homework first.
Be sure any dividend-paying stock you do invest in earns plenty of free cash flow to maintain — or even better, to increase — its dividend payout.