The dividend payout ratio.
It's what we need to figure out to answer the question, “Can this company afford to pay my dividend?”
In this article, I'm going to share …
- How to be a high-yield income investor without falling into a dividend trap.
- How to calculate the dividend coverage ratio to ensure the company can cover our dividend.
- How to calculate an even better ratio – the cash dividend payout ratio – to REALLY make sure the dividend is sustainable.
High-Yield vs Low-Yield
First, I want to address one of the big debates about investing for income and that is high yield vs low yield.
As income investors, we invest for income… duh.
And the income we get is relative to the price we pay to invest and it's expressed as a yield.
If we pay $25 a share for something and it pays $1 per share annually in income also known as a dividend, then the yield from that investment is 4%. We just divide the annual income by the price we paid for the share.
So, there are a few assumptions about how we invest and what we are seeking…
First, we focus on high yields.
In my Income Investors Academy, I have an income investment plan builder that all members get to help them build their investment plans.
It’s called the Personal Profit Planner and it’s designed to create a path from where you are now to where you want to be… financially.
This is the plan that I created for myself several years ago when I realized I needed to seriously pump up the jam on my investment returns and retirement savings.
My personal plan is based on a target yield of 9%.
And that target yield is for my income bucket only. That bucket that holds 80% of my investments.
I don’t have that same requirement of my growth or value buckets because they either pay lousy yields or none at all.
That means that at the end of the day, when I average the income yields that all my investments in my INCOME bucket are paying me, in order for my plan to work, they need to average 9%.
Does that mean I don’t own any investments yielding less than 9%?
I own many that pay less than that.
But if I buy something that yields less than 9%, I make sure I have an offset to the high side.
Meaning if I buy something that’s only yielding 8%, then I need to also hold a 10% yielder so the average is 9%.
So, let’s look a little closer at this whole high yield vs low yield debate to see what we’re really dealing with here.
High Yield vs Low Yield
The classification of a high-yield stock is relative to the criteria of any given analyst. Some analysts may consider a 2% dividend yield to be high, while others may consider 2% to be low.
There is no set standard for judging whether a dividend yield is high or low. But the bottom line is that many analysts use the comparison between the stock's dividend yield and the 10-Year US Treasury Note.
Which today is yielding 1.74% by the way.
Some folks who pay attention to the mainstream financial press might then say, “Ok Susan you sold me! I’m out of treasuries and I’ll dump my money in an ETF that tracks the S&P 500. That’s what Warren Buffett says to do and he is a billionaire!”
To which I respond, if a billionaire told you to jump off a bridge or better analogy in this case LIVE UNDER ONE, would you do it?
Let’s hope not because the yield of the famous Vanguard S&P 500 ETF is a measly 1.93%
Now, I’m no math genius but if the inflation rate is 1.8% and the yield my investments are paying me is 2.0%, my fear of being a full on bag lady in retirement is likely to come true.
And since my investment plan could alternatively be titled Operation Bag Lady Avoidance, this smells like disaster to me.
So, my focus is unapologetically HIGH YIELD.
And did you know that high-yield stocks tend to outperform low yield and no yield stocks during bear markets because many investors consider dividend paying stocks to be less risky?
It’s totes true. TOTES!
If we look back at history, travel back with me now, friend…
We find that dividends have historically been much less volatile than stock prices.
I’m a nerd so I researched two things going all the way back to 1900…
Dividend Growth and Share Prices
The worst period since 1900 was a 34% decrease in dividends while the decrease in share price dipped almost two times that to a decrease of 62%.
One super interesting thing I discovered when I plotted this stuff on a graph, was that during the worst financial crises in our country like the 1929 stock market crash the share prices tanked and the dividends INCREASED!
So, for all my friends concerned about dividends getting cut when things get tough, take note y’all!
The bottom line simply is the guy who’s 40 years old starting with $100,000 making a 2% yield will grow it to $164,000 in 25 years and the girl who’s 40 starting with $100,000 making a 9% yield will grow it to $862,000.
That’s 425% more.
And that’s good enough for me.
OK, so what are the risks?
We all have been indoctrinated that high yield means high risk and that low yield means low risk. But is that always the case?
I don’t think so.
In fact, my I12 Income Acceleration system has identified 12 income investment strategies that I shared in this podcast episode that offer what I call asymmetric returns – high yield with relatively low risk.
High Yield Investment Strategies
Even though I've identified 12 high-yield investment strategies, does that mean that we just go for the stock with the highest yield and call it a day?
No. That would be insane.
Because there is that inverse relationship between share price and yield if a yield is really high then it usually means there’s trouble with the company and that’s no bueno.
The Dividend Yield Trap
Like GameStop for example. Apparently no one wants to buy video games at GameStop anymore they all just want to stream digital games like Fortnite.
And the fact I even know what that sentence means is only because I have a 14 year old nephew. If you ever want to keep your finger on the pulse of what’s hot, make sure you have a 14 year old in your life.
And even though Gamestop was paying a ridonkulous 37% yield on a share price of $4, that’s not a company you want to invest in for income right now.
Because with revenue and earnings declining like crazy, that dividend will be cut or eliminated altogether since it’s not at all sustainable.
Dividends are typically paid out of earnings which are profits.
And in the case of GameStop, they were paying $1.52 in annual dividends and last quarter they lost $6.79 per share.
That’s how folks go bankrupt. Trying to pay $1.52 when they lost $6.79.
And guess what? Our story ends just the way I expected it to – Gamestop suspended their dividend in June.
So all the folks who owned it as an income stock because they were chasing unsustainable high yields didn’t get a paycheck that quarter.
Now it may be a candidate to add to the value bucket of our portfolio – one that has dropped really low and that we hope will turnaround and come back but that’s a whole other show.
The point is just because a yield is the highest doesn’t make it safe. Or sustainable. So choose wisely.
Can The Stock Afford to Pay Us?
Here’s a quick way to see if the company you’re considering investing in can actually afford to pay your dividend…
Are the earnings per share higher than the dividend per share?
If they are, cool they can afford to pay us. If not, they can’t.
On some stock research sites you’ll see this expressed as the payout ratio.
The Dividend Payout Ratio
The payout ratio is is the percentage of net income that a company pays out as dividends to common shareholders.
A payout ratio of 10% means for every dollar in Net Income, 10% is being paid out as a dividend.
For instance, if Microsoft earns $50 million in net income and the payout ratio is 25%, Microsoft will offer $12.5 million to all its common shareholders.
GameStop’s payout ratio is NEGATIVE 22%.
No wonder the share price looks like a straight shot down…
An even better way to really make sure a company can afford to cover its dividend is with what’s called the cash dividend payout ratio.
The Cash Dividend Payout Ratio
The Cash Dividend Payout Ratio is the proportion of free cash flow (after preferred dividends) that is paid as dividends to common shareholders.
That means if Microsoft generates $50 million in operating cash flow, has capital expenditures of 20 million, pays preferred dividends of 10 million and pays common dividends of 5 million, Microsoft has a cash dividend payout ratio of 25%. 5/(50-20-10)
Because net earnings really easily manipulated and cash flows are harder to manipulate, this cash dividend payout ratio is a lot more useful to analyze cash flow being paid in dividends.
If this number is really high, or greater than 1 or 100%, it means the company is paying out more in dividends than it is receiving in actual cash.
Poor broke GameStop’s cash dividend payout ratio is currently 161%.
So, there ya go my friends.
High yields are better and more profitable for investors but the highest yields aren’t always better or more profitable. In fact, they can be what we call a dividend trap.
And now you know exactly what to do to avoid that trap.