There are three payout ratios that are used most often with dividend investing: payout ratio, forward payout ratio, and free cash flow payout ratio. What are they and which ones should I use?
A payout ratio is a way to attempt to show the safety and possible growth of a dividend. The lower the payout ratio, the better potential dividend growth. During times of economic stress, a low payout ratio can be used as one piece in the puzzle to help determine the safety of a dividend. The other pieces being expenses, free cash flow and other fun metrics.
What are they?
There are several types of payout ratios I use. They are:
- Payout Ratio: This payout ratio takes the current 12 month dividend and divides it by the trailing twelve months (TTM) of earnings per share (EPS).
- Forward Payout Ratio: This payout ratio takes into account the current 12 month dividend and divides it by the projected EPS over the next twelve months.
- Free Cash Flow Payout Ratio: Takes the amount paid in dividends over the previous twelve months and divides it by the Free Cash Flow (FCF) generated during the TTM.
The payout ratio that should be used depends on the industry. Generally, I try to stay below a 60% payout ratio (this number is a matter of individual choice). However, some sectors will have a higher payout ratio because there is only so much they can reinvest in the business. Two sectors that come into mind are utilities and tobacco companies.
Issues with each
The main issue with the payout ratio is the fact that it uses earnings per share (EPS). EPS can be affected by charges that are not necessarily accrued at one time or by charges that are merely an accounting requirement. Take Starbucks (SBUX) for example. According to SBUX 2013 annual report they earned $.01 per share. Or did they? It turns out in Q4 2013 they finished arbitration with Kraft, which resulted in a $2.25 charge to earnings. The claim was not paid in Q4 2013, but will be funded with cash and debt at a later date.
SBUX is currently paying .26 per quarter ($1.04 per year). So which do you use? .01 or 2.26? Or in terms of Payout Ratio 1.04 / .01 = 10400%? or 1.04/2.26 = 46%? This case is a drastic example, but suppose SBUX only had a charge of $1. Then the payout ratio would be 1.04/1.26 = 82%, still high but not necessarily high enough to make you want look deeper. For this kind of investment, one falls below my 60% rule and the others are well above. It takes some due diligence to make sure that a charge off doesn’t skew your results, or you could miss out on a good investment opportunity.
After reading enough reports, you will see that charge offs are fairly common. Generally, the bulk of what I have seen are a couple pennies. It is only in the rare case that one is much larger. The SBUX write off is the largest I have personally seen.
Forward Payout Ratio
The Forward Payout Ratio has only one main issue that concerns me, that is the nature of telling the future. This ratio uses earnings projections for the next year to determine what the payout ratio is today. In order to use this number and be confident in it, you must understand the business and what is possible in terms of earnings growth. Earnings growth can be affected by a large number of things. The economy, share buybacks (almost artificial earnings growth), issuing shares, etc.
Free Cash Flow Payout Ratio
The Free Cash Flow payout ratio is my preferred ratio. This divides the previous TTM dividend with the actual cash the was generated after paying expenses and capital expenditures. I like this ratio the most because it uses money the company actually made as part of the ratio. Like the payout ratio, I would like this to be below 60%. If this ratio is above 100%, then that will require some additional digging to figure out why.
On the plus side, the free cash flow of a business is less affected by many of the same problems that arise when calculating EPS (charge offs, accounting gimmicks, etc). It is the cold hard case that the company generated. The main issue with this ratio is that it is a historical number. It’s a measurement of what was done and as we all know in investing “past performance does not guarantee future results.”
Using a combination of the Payout Ratio, Forward Payout Ratio and Free Cash Flow ratios can be part of the process for helping to determine the safety, sustainability and growth potential of a dividend. Each has their flaws, but provide insight into the overall picture.