What a Dividend Payout Ratio Can (and Can't) Tell You

Question:

In a recent article exploring the valuations of stocks in the Morningstar Dividend Yield Focus Index, a few readers wondered whether

Answer: The payout ratio is a very useful metric for evaluating a dividend-paying stock. The calculation is simple enough: It's the proportion of a company's earnings paid out as dividends.

A lower payout ratio can sometimes indicate that the dividend is "healthy"; in other words, there is a margin of safety that would allow a company to miss its earnings target and still be able to pay out its dividend, and there may also be room for management to increase the dividend over time. A payout ratio over 100 may indicate that the dividend is in jeopardy, because no company can continue pay out more than it earns indefinitely.

A very high payout ratio can be a sign to investigate further, but it's not necessarily a signal to run screaming. As discussed in this video, consumer staples, utilities, and telecoms tend to generate very steady revenues and cash flows. A high payout ratio might not be as much of a concern at a more stable firm such as these, but it could be a bigger red flag at a more cyclical firm or one that carries a lot of debt on its balance sheet.

Further, while a payout ratio can tell you a lot about a company's ability to continue paying and possibly grow its dividend, there are some caveats. The biggest one is that the denominator--corporate earnings--can be reported in a number of ways.

Which Earnings? A company's earnings may seem like a straightforward number reported each quarter, but company management and analysts alike often like to look at earnings through different lenses to get a clearer view of the underlying strength of the business. One can consider earnings per share from many different angles: core EPS that excludes one-off items versus the profits reported under generally accepted accounting principles; known earnings from the recent past versus those projected for the future; current earnings versus a cycle average; and more.

Likewise, the payout ratio can also be calculated and considered in many different ways. Let's take Pfizer: As our reader pointed out, Pfizer's payout ratio, using calendar year-end data information, is 118%. That sounds a little precarious, no? It doesn't seem logical that a company can pay out more cash than it earns indefinitely. But over the trailing 12-month period, that's what Pfizer did: It paid out $0.28 per share in the fourth quarter of 2015, then it paid out $0.30 per share in each of the first three quarters of 2016. Pfizer's diluted earnings per share were $1.00 ($1.18/$1 = 1.18).

Morningstar healthcare analyst Damien Conover explained that Pfizer's high payout ratio owes to some one-time items weighing down net income over the trailing 12-month period; he believes the company's dividend is safe.

"Pfizer's payout ratio is impacted by GAAP costs (amortization) and restructuring costs," he said. "The normalized earnings support a payout ratio of around 50%, in line with the group average."

GAAP vs. non-GAAP GAAP stands for generally accepted accounting principles, which are reported along with a company's "adjusted" or "pro forma" earnings. GAAP accounting rules are important because they standardize financial reporting, allowing for easier comparisons, and they also guard against financial manipulation--companies aren't allowed to choose what information they want to disclose and what they would prefer to hide. GAAP is based on accrual accounting, which means that revenues and expenses are recorded when they are incurred, regardless of when cash is exchanged.

But sometimes non-GAAP earnings can also provide a useful view of a company's earnings. Non-GAAP earnings can tell you a lot about the normalized strength of a company's earnings (earnings before interest, taxes, depreciation and amortization is a common non-GAAP measure). These figures usually exclude one-time or noncash expenses, such as those related to acquisitions or restructurings.

In its third-quarter earnings press release, Pfizer management details the amortization and restructuring costs that led to the discrepancy between its reported GAAP earnings per share--$1.03--and its non-GAAP adjusted EPS--$1.91--for the nine months ended October 2016.

But what about going forward? Pfizer's quarterly dividend is currently $0.30. From here, we can get an estimated annualized dividend yield: $0.30 * 4 = $1.20. The consensus EPS estimate for 2017 is $2.60. Dividing $1.20 by $2.60 is about 0.46, which, as Conover points out, is in line with Pfizer's payout ratio under a normalized earnings scenario.

Putting It Together In sum, the payout ratio is a very useful tool, but it helps to put it in broader context. First, know which type of earnings is used to calculate the ratio, and decide whether that is really providing an accurate view of a company's cash-generating ability.

Second, there is no one-size-fits-all level or magic number for the payout ratio; it's helpful to consider the ratio in the context of how volatile a company's earnings tend to be, as well as the financial strength of the company.