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

Note: This article is part of Morningstar's Guide to Dividend and Income Investing special report. A version of this article originally ran on May 12, 2016.

In an article discussing the valuations of stocks in the Morningstar US Dividend Growth Index, we featured

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"--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 to 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 more stable firms 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 Hanesbrands: The payout ratio, using calendar year-end data information, is 353%. 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 Hanesbrands did: It paid out $0.60 per share in each of the four quarters of 2017. Hanesbrands diluted earnings per share were $1.00 ($0.60/$0.17 = 3.53).

Senior equity analyst Bridget Weishaar explained that Hanesbrands' high payout ratio owes to some one-time items weighing down net income over the trailing 12-month period; she believes the company's dividend is safe.

"In 2017, Hanesbrands had a number of one-time charges related to the effect of U.S. federal income tax reform and pretax charges for acquisition integration as well as other charges," she said. "Going forward, excluding one-time charges, we see the payout ratio averaging 33% over the next five years, which we view as reasonable. This is in line with the three-year average of 2014-16."

GAAP versus non-GAAP Generally accepted accounting principles 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 fourth-quarter and full-year press release, Hanesbrands management details the amortization and restructuring costs that led to the discrepancy between its reported full-year GAAP earnings per share--$0.17--and its non-GAAP adjusted EPS--$1.93--for the full year 2017.

But what about going forward? Hanesbrands quarterly dividend is currently $0.15. From here, we can get an estimated annualized dividend yield: $0.15 * 4 = $0.60. For full-year 2018, analysts' consensus EPS estimate for Hanesbrands is $1.76. Dividing $0.60 by $1.76 is about 34%, which, as Weishaar points out, is in line with Hanesbrands' payout ratio under a normalized earnings scenario.

Putting It Together 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.