The Most Important Dividend Metric In Difficult Times

by: Dividend Diplomats

I was laying in bed thinking of this day and age, the performance of companies and how critical attributes are in determining what is the absolute most important metric for a dividend stock you own. I began reviewing the list of stocks that I currently own, you name it - Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), AT&T (NYSE:T) and other big dividend aristocrats, and I finally saw the trend of what made my stomach feel uneasy and what made it feel comfortable. That metric was the payout ratio.

The most important dividend metric in difficult times - The Payout Ratio

How did I come across the payout ratio? Well, first off - it is one of the screening filters in the dividend diplomat stock screener, but that's not exactly how I landed on this conclusion. It's actually a combination of sorts - experience, performance and safety - that allowed a conclusion such as that to form. There are a few intricacies to this payout ratio, but let's provide a terminology for the readers. Your payout ratio is…

Total Dividends Paid/Total Net Income OR $Div Per Year/EPS

Simple enough right? Now, I've seen payout ratios all over the place from 0% to well over 100% (which is the danger zone); as well as even negative percent (which is territory that just doesn't make sense… when you have net losses and you're paying a dividend…). Then, from our preferred range we have the sweet spot at roughly 40-60%, which essentially breaks down to - the company keeps close to half of their earnings and pays out half to the shareholders. Bottomline - we've seen it all.

Next, I'd like to ask this - How many investors, shareholders and others have seen their companies struggle to keep up with earnings? How many have cut expenses so much that there is nothing left? How many are having difficulties with also top-line revenue? I've seen more and more of that, with Apple (NASDAQ:AAPL) being a great example. I wanted to do a little more research and online I found the average earnings per share by year for the S&P had hit a peak on 12/31/14 and then declined down to 87.12, which is lower than what it was at 12/31/11… a.k.a. the earnings has slid a bit and are not as strong - giving prompt to why I feel the payout ratio is such an important dividend metric, during economically difficult times (insert.. OIL). Please see the chart of EPS by year from this website:

S&P earnings

Think of all the crisis that are occurring around the world right now. Oil. Isis. Zika. Elections. 99% vs. 1%. Every single crisis is having dramatic impacts on industries and earnings. The proof is in the pudding. Further, I even received a report from this site (one of my favorites now); to which in it, it reads:

Click to enlarge

As you read in the 2nd sentence - the dividend payout ratio in their Q4 analyzed (which is ending 1/31/2016) increased 15.4% YOY! Whoa. Why? Earnings are down, and that makes sense. Further - the opening to sentence one brought it right out of the book. The S&P 500 ratio is fairly safe, though, at 38%.

Experience with the Importance of the Payout Ratio

Now - theory and literature is great, but how about from experience? Well it doesn't take more than Bert to tell you about my analysis of FirstEnergy (NYSE:FE) (a reason why Bert is debating on selling the stock) back a few years ago. Its earnings were slumped, and operating cash flows were way too tight. I told him and a few others - a dividend cut has to occur, as the payout ratio far exceeded 100% and exceeded it for far too long. It wasn't until a few weeks later and in early 2014 - boom, dividend was cut. Obviously, with the oil & commodity prices, I don't even have to tell you about the misery with Kinder Morgan (NYSE:KMI) and shortly thereafter - wonderful BHP Billiton (NYSE:BBL). And guess what? payout ratios still explode through the roof with the biggest oil player in Exxon Mobil (NYSE:XOM), with no cuts but then the cut occurred with behemoth ConocoPhillips (NYSE:COP) back in February. I have learned from experience that a safe payout ratio is key and critical to a dividend investor, without a shadow of a doubt. My forward income was slashed in the hundreds from this… picture if you were someone who had previously generated thousands from the dividend stream? O U C H.

Why is this so important? Because - with dividend entities that have a nice solid growth rate, which we do love, they need to watch out for the ceiling or the 100% payout ratio ceiling. The closer you are to hitting your head on the ceiling, the more you ask the question - is this sustainable? Can the dividend not only be paid but can they still continue with the increase? With the diplomat screener of between 40-60%, for sure, but earnings can derail fairly quickly to cause the ratio to skyrocket.

Examples of recent purchases that have more safety to them than meets the eye: When we purchased T. Rowe Price (NASDAQ:TROW) a few months back, they were at roughly 47% and then with Archer Daniels Midland (NYSE:ADM) recent purchase in January, the payout ratio was mid-30% range (36%). They can sustain earnings hits, while maintaining and even raising their dividend at a lower rate than usual. Then… when performance is better than normal - growth can return to a more normalized level.

Conclusion & Summary on the payout ratio

As you can see from above - I am falling more into the payout ratio screen. I believe as a dividend investor during these troubled earnings times, it is ever so critical. The oil crisis that we are going through now has shed more light on that than ever, and it's a learning lesson we can all take. What does everyone think of the payout ratio? Do you have a set range you look for? What is too high for you? Do you have too low of a point? Also - any experiences to share? Thank you again for stopping by everyone, looking forward to the comments and as always - happy investing.