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Summary

  • The author argues that the payout ratio is a key factor in determining whether a company can grow dividend payments in the future.
  • The author analyses the payout ratios and relative performance of ABC, CVX, KO, PG and WFC to assess the risks of high yield investing.
  • The author determines that companies with excessively high payout ratios are at risk of poorer performance than that of companies with growth and sustainable yields.

"The only thing that gives me pleasure is to see my dividend coming in."

- John D. Rockefeller

I'm sure I'm not the first one to use the above quote on SA, but for investors seeking a regular income for retirement, financial independence, etc, dividends are considered the holy grail. The great thing about dividends - the higher an investor's committed capital, the greater the cash flow returned to him/her on a regular basis. It's little wonder that Rockefeller with all his riches took pleasure from seeing them roll in on a regular basis. Therefore, the greater the dividend yield, the better, right? Wrong.

For investors seeking to generate cash flow through regular dividend income, there are two important factors to consider:

1) whether the yield meets an investor's needs based on his/her circumstances, e.g. time to retirement, asset allocation, etc.

2) whether such yields are sustainable over the long term.

Blindly chasing high-dividend stocks always presents the danger that the company will not be able to sustain such high yields indefinitely. When a company generates earnings through its business, it can do one of two things - it can either reinvest the proceeds into the business or it can simply pay the profits to shareholders. A high dividend yield simply means that the company is paying a significant amount of dividends to its shareholders and this may mean that the company risks low growth in the future, threatening both share price appreciation as well as dividend growth. And, as they say, if you're not growing, you're shrinking. This is why Berkshire Hathaway adamantly refuses to pay dividends to its shareholders. From their perspective, it is much more profitable over the long term to reinvest cash flow into profit-generating assets. Therefore, this is why I personally don't support strategies such as buying the 10 highest-yielding Dow stocks, etc. The company must show it is generating profits from its current activities. Enter the payout ratio.

The payout ratio allows us to quantify how much of the firm's profits is being paid to shareholders. The method I use in this article to calculate this metric is Dividends Per Share/Earnings Per Share.

As per the below, I analyze the payout ratios and relative performance over a 5-year period for five companies on the S&P 500; AmerisourceBergen (NYSE:ABC), Chevron (NYSE:CVX), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG) and Wells Fargo (NYSE:WFC).

AmerisourceBergen

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Chevron

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Coca-Cola

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Procter & Gamble

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Wells Fargo

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Overall Performance

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- It can be seen that AmerisourceBergen has had the highest share price growth over the past five years (based on closing price not adjusted for stock splits or dividends), and also has the lowest payout ratio and dividend yield.

- Coca-Cola has also been on the lower end of the spectrum in terms of share price growth at a 5-year average of 39.35%, representing a yearly average of 7.87%. It is notable that the company also has the highest dividend payout ratio of the five companies and a dividend yield in the 3% range.

- While one cannot generalize based on the above five examples, it would appear that there is a negative correlation between share price growth and the dividend payout ratio, i.e. the higher the payout ratio, the lower the growth and vice versa.

In conclusion, dividend investors would do well to look at the payout ratio when deciding whether to invest in a company. Not only does a high dividend yield have the potential to be unsustainable, but any gains in dividends could be superseded by lackluster share price performance.

Source: Dividend Investing: Look At The Payout Ratio, Not The Yield