Dividend investing is very important for portfolio builders and income investors. From the most fundamental of all stock valuation methods, a stock is worth the present value of its future cash flows. When a company has earnings, it can either pay those earnings out as dividends (if they have the cash) or it can reinvest those earnings back into the company. Very mature companies will pay more dividends because they have fewer profitable projects to invest in. When companies have a higher dividend yield than earnings yield (earnings/price), this means that the company is liquidating itself, which is important for its investors to understand.
In this article, I discuss five large-cap stocks with payout ratios over 100 percent and what it means for the future of each company.
Plains All American Pipeline (NYSE:PAA): Payout Ratio: 131.7%
Plains All American Pipeline currently has a P/E ratio of 20.23 and a dividend yield of 6.51 percent. Being a crude oil pipeline and storage company, it is obviously in a mature industry that dividend investors flock to. As of its June 30th balance sheet, Plains reported $23 million in cash, which seems like very little for a company with $5 billion of long term debt and a $9 billion market cap. Plains is obviously working with very low liquidity numbers. Its secondary public offering which closed on August 17th, $1.6 billion credit facility on August 22nd, and its $850 million inventory facility on August 22nd shows that it needs cash. On the positive side, Plains is expected to have earnings per share of $3.81 in 2011, up 55.5 percent from 2010. Plains may simply be banking on its future earnings to justify such a high payout ratio, but when companies shell out dividends and then raise capital, you have to be careful when evaluating companies based purely on their dividend yields. I think PAA is an okay stock to buy, just don’t be impressed with its high yield.
Enterprise Products Partners (NYSE:EPD): Payout Ratio: 154.6%
Enterprise Products Partners is an energy company with a P/E ratio of 26.33 and a dividend yield of 5.87 percent. In the last three quarters, it has earned 50 cents, 47 cents, and 37 cents, respectively, yet has paid dividends of 61 cents, 60 cents, and 59 cents, respectively. Out of 21 analyst recommendations on Yahoo! (NASDAQ:YHOO) Finance, 10 analysts rate EPP as a “Strong Buy” while 9 rate it as a “Buy”. Much like with Plains All American, EPP’s competitors are also producing payout ratios of over 100 percent. These companies are liquidating themselves, yet investors and analysts tend to buy up these stocks and help them achieve massive P/E ratios. I understand that energy companies can increase revenues and earnings without any substantial new investments, but what I do not understand is why investors are willing to pay a 26 times earnings multiple for a company that is liquidating itself, when there are plenty of growing companies on the market trading at P/E ratios between 8 and 12.
FirstEnergy Corp. (NYSE:FE): Payout Ratio: 124.0%
FirstEnergy has a P/E ratio of 24.56 and a dividend yield of 5.05 percent. FirstEnergy is expected to earn $3.34 per share in 2011 which would put it at a P/E ratio of 13.05 if its stock price stayed the same. In addition, it is a fairly liquid company in comparison to competitors, reporting cash of $398 million on its 6/30 balance sheet and $1.1 billion on its 3/31 balance sheet. FirstEnergy is much like other energy companies in that its revenue and earnings have not been increasing. A 5.05 percent dividend yield is a decent price for a company with no growth prospects, and the lack of growth in energy is a major reason why energy companies are willing to pay such high dividends. However, whether or not these dividends continue to keep coming long term is very questionable.
Merck and Company (NYSE:MRK): Payout Ratio: 110.1%
Merck is in a completely different industry (healthcare) than the previous three companies, and has a lot more liquidity. It has paid a quarterly 38 cent dividend since 2004, and its high payout ratio is more a result of inconsistent earnings than an unsustainable dividend yield. Merck reported over $16 billion in cash and investments on its 6/30 balance sheet, so liquidity is not a problem. Companies like Merck usually carry a lot of cash on their balance sheets to remain flexible and have the capital to invest in research for new scientific trends right when they appear. Merck’s dividend yield is strongly justified since it has the capital and earnings expectations to continue paying out its dividend, which Merck has shown over the past seven years.
Energy Transfer Partners (NYSE:ETP): Payout Ratio: 222.75%
Energy Transfer Partners has a P/E ratio of 27.74 and a dividend yield of 8.03 percent. The company has paid a consistent quarterly dividend of 89 cents since 2008, but an earnings decline has caused the company to have its abnormally high payout ratio. With $133 million in cash and $7.638 billion in long term debt on its 6/30 balance sheet, it is hard to imagine that Energy Transfer Partners will be able to maintain its dividend. It is hard to see why these companies are willing to put their liquidity on the line just to keep up their dividend payments.
From the companies listed above, we can see a few reasons why companies have payout ratios over 100 percent. They try to keep their dividend payments consistent to satisfy investors, their companies are getting smaller so they boast high dividend yields since there are no profitable projects that the company wishes to undertake, or they have a lot of cash and can sustain a high payout ratio until earnings increase.
These are not the only five companies with payout ratios over 100 percent. A quick look at these companies’ competitors will show that this is more of an industry trend in the energy and health care industries. We will wait and see if these companies can boost earnings and sustain their dividends or if they will have to shrink as companies or lower their dividends. The one thing that is certain is that investors still go to these stocks in hard economic times because they are trying to invest for quick liquidity.
I believe investing for high dividend yields is a good strategy, but there are several stocks out there who compete with these high-payout companies, like Eli Lily (NYSE:LLY) and Duke Energy (NYSE:DUK), who boast similar dividend yields but have the earnings to back up their dividends.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.