If you’re planning on buying a dividend paying stock, it’s important to do your homework and analysis before putting your hard earned cashola to work.
In my post about dividend yields, I mentioned to be cautious about companies that are paying out too much in dividends from their earnings. To find how much they’re paying out form their earnings you want to look at the Earnings Per Share Payout ratio.
To determine dividend safety and sustainability, there’s a series of metrics you can look at. The EPS payout ratio is only one of a few of these metrics. The basic idea of checking dividend safety, is you want to be able to tell if the company can afford their divided.
The EPS payout ratio is an easy one to learn and a good place to start. It might just keep you out of some high yield traps.
What is the EPS payout ratio?
The earnings per share payout ratio is a metric that tells you how much of the companies’ earnings are being paid out as a dividend.
It’s important to look at this ratio when looking at a dividend paying stock. As you’ll want to know how much it’s paying out relative to how much money the company made.
If a company was paying out all its earnings as a dividend it wouldn’t be sustainable. There’s no room to cover any unexpected costs or no room to fund growth in the business. Then eventually the dividend will be cut, saying good buy to that income you’d either started to rely on or had plans to rely on.
How to calculate the payout ratio.
Now you know why it’s important to see how much of the earnings the company is paying out as a dividend, you’re probably asking how to calculate it?
The 2 pieces of information you need are the EPS and Dividend Per Share (DPS) and is worked out as:
(Dividend Per share / Earnings Per Share) x 100
Let’s assume we have the information for Company ABC, which has an EPS of $2 and a DPS of 50 cents. So, we’ll work it out as:
(0.50 / 2) x 100 = 25%
The 25% is telling us, 25% of the earnings are paid out as a dividend. What’s happening to the other 75% of earnings? That will be retained for future investment into the business to fund growth.
A real example
I’ll use Crown Casino (ASX: CWN) to see how much of their earnings in 2019 was paid out as a dividend.
In 2019 they had a Diluted EPS of 59 cents and paid out a dividend per share of 60 cents. Let’s work it out to see if this is sustainable.
(0.60 / 0.59) x 100 =101.69%
In 2019 Crown casino paid out 101% of their earnings as a dividend. That is not sustainable, no company can pay out 100% of earnings without some kind of repercussion. Even if we didn’t have the Coronavirus, I’d assume their dividend would have been cut eventually.
What’s a good payout ratio?
Most people who’re conservative dividend investors like anything from 40% to 60%. Though I can live with a 70% to 80% of earnings being paid out. This acceptable payout ratio for me is also dependent on what country the company is based in.
If you’re investing in American dividend paying companies, they have lower payout ratios as they prefer to retain more earnings for future growth or focus the cash into stock buybacks.
Though, in Australia because of the franking credit system, it’s tax advantageous to pay out most of the earnings as a dividend. You’ll find most Australian companies have high payout ratios. They’ll raise and cut their dividends as their earnings fluctuate. That’s not ideal. But, I guess if the dividend is consistently rising over time then we can live with that.
What do you think, do you look at dividend safety when analyzing a dividend paying stock? Let me know in the comments below.