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Payout Ratios Can Reveal Dividend Stability

And how else can investors keep watch?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Dividend stock investors rely on a company's payout ratio to determine a dividend's stability. Joining me today to discuss the ins and outs of payout ratios and how to effectively use them is David Harrell. David is an editorial director with Morningstar Investment Management and editor of Morningstar DividendInvestor.

Thanks for being here today, David.

David Harrell: Great to be here.

 Let's start out by defining our terms. What is the payout ratio? What does it tell us? And how is it calculated?

Harrell: Sure. So payout ratio is simply a measure of the portion of a company's earnings that it's returning to shareholders via dividend payments. So if a company earns $5 per share, and it's paying out to $2.50 a year in dividends, it'd have a 50% payout ratio. If it then raised its dividend to $3, that payout ratio would increase to 60%.

Dziubinski: Now, does a high payout ratio always mean that there's, you know, the dividend might be at risk?

Harrell: Not necessarily. So with the payout ratio, you really want to look at it in context, and in context of several things. First of all, there are mature wide-moat companies that routinely payout a large portion of their earnings as dividends, particularly in certain sectors, such as utilities, for example. So you need to look at the payout ratio relative with things like: What's the payout ratio of other firms in the same sector or industry? Where does the payout ratio stand relative to management's target for the payout ratio? Oftentimes, management will say, "We intend to return 55% to 60% of earnings as dividends." Where is that payout ratio relative to that? And then finally, look at the payout ratio, how it's changed in recent years. And a good tool for this is go to, go to a stock report page, go to key ratios, and you can see the payout ratios over the past decade.

If a payout ratio has increased quite a bit over the past few years, is that because management is simply returning more and more cash to shareholders via the dividend? Or has the dividend remained the same, earnings are eroding, so you're seeing the payout ratio become much larger because of that smaller earnings amount? And that's a situation where it might be a cause for concern. Now, clearly, in 2020, we saw a large number of firms have their payout ratio spike, in some cases over 100%. Now, firms that were sort of healthy dividend-payers with strong cash reserves were able to cover their dividend, even if it exceeded their earnings for the year. So they had that temporary spike in a payout ratio, but now we're seeing some of those payout ratios return more to their normal range.

Dziubinski: So, then on the flip side, if you see a low payout ratio, does that automatically mean "Ooh, this is the stock that's going to give me some dividend growth?"

Harrell: Well, there's a tendency to look at that and say, "Wow, a low number. There's 'room' to grow the dividend." And that certainly can be the case, particularly if you have a younger company that might have only initiated its dividend a few years ago. They might tend to start out small, but management might have every intention of increasing that payout ratio, increasing the dividend, and you might expect to see it to grow. But here's a case where you really want to have a better understanding of where the dividend stands in terms of prioritization of the company's asset allocation. A company might have a low payout ratio, but the dividend might be relatively low priority. It might come last. They might have debt they're paying down. They might have a lot of money they want to spend ... they might want to devote a lot of funds to R&D. They might actually be more devoted to buybacks than dividends. So here is something where you just really want to have a better understanding of the prioritization of the dividend.

And there's a couple of places you can look for more information on that. One would be just the shareholder letter in the annual report. Oftentimes, you'll see management tout their dedication to the dividend, the length of, the streak of dividend increases and reiterate that, "Yes, we are devoted to growing the dividend." A better place might even be some of the transcripts of the quarterly earnings calls. Oftentimes you'll get questions from analysts about upcoming dividend increases, and that's a place where you'll see management literally lay out their priorities for capital allocation and where the dividend stands and if it's first in line or third in line. That's a way to have a better understanding of management's intention to grow the dividend.

Dziubinski: David, what other factors might dividend-seekers be looking at besides that payout ratio if they're trying to find stocks that have stable dividends?

Harrell: Sure. Dividends don't come out of thin air. The cash to pay that has to come from a company's earnings and cash flow. Companies need stable earnings to pay their dividends. They need increasing earnings to increase their dividends. And one tool that investors might use is the Morningstar moat rating. Now moats certainly don't guarantee dividends. But every time we've looked at the relationship between moat ratings and dividends, we've seen a fairly strong correlation. For example, in 2020, no-moat companies were the ones that were most likely to have suspended or reduced their dividends, whereas wide-moat companies were the least likely to have cut or suspended their dividends.

Well, David, thank you for your time today and for giving us your perspective on this metric, the payout ratio, that's very important to dividend investors. We appreciate your time.

Harrell: Thanks for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.