Dividend Yields and Payout Ratios
By PAIP Canada staff
Having discussed share buybacks last week, we now want to consider dividend yields and payout ratios. Dividends are typically a share of a company’s profits, and are sought after by investors. They signal continued prosperity of the company in question. If a company can’t afford to pay its dividend, then shareholders would receive nothing.
Regarding the companies that do pay dividends, it’s important for apples to be compared to apples and oranges compared to oranges. As each industry has different capital requirements and different margins, dividend yields and dividend payout ratios should be compared within each industry, but not across different industries.
The payout ratio is the total amount paid in dividends divided by the total amount of net earnings. This calculation can also be done on a per share basis. As an example, Canada’s banks have traditionally paid out close to 40% of their earnings (in the form of dividends), but this ratio has increased in recent times as the industry finally reaches a mature stage.
When one company is offering substantially less than its competitors, it may signal a higher opportunity for growth.
When considering a company’s dividend yield, it’s calculated as the dividend per share divided by the share price. Expressed as a percentage, investors typically seek high dividend yields due to their larger reward.
Where the investing process gets interesting, is when an investment with a low payout ratio and a high dividend yield is uncovered. With a low dividend payout ratio, there’s the opportunity for increases in the future. Dovetailing with this is the potential for a share price increase (given its high dividend yield).
When investing, each investor has a required rate of return. As an example, if that amount is 10% for a given security, then a dividend yield of 4% means the price return must be no less than 6%. Had the company not paid any dividend at all, then the price return required would be the entire 10%.
Although many will read this and believe that a high dividend yield will translate to higher returns, this is not always the case. In many situations, a company’s total return is going to be the same whether a dividend is paid or not. A company’s performance does not depend on the dividend. Instead, it’s the dividend that depends on the company’s performance. In situations where a company continues to pay a dividend while seeing its total profitability erode, it’s a bad sign. Eventually the company will end up in debt (to finance the dividend), or the dividend will need to be cut.
Analyzing a company’s dividend is important, but pulling the curtain back is even more important. Diligent analysis takes time, but the rewards will be worth it.