When I sit down to select dividend-paying stocks for my readers, my personal portfolio, and my mother’s portfolio, I don’t just consider the “usual” numbers…
Of course, I look at important things like brand quality, profit margins, and sales growth…
But I also use a little-known, very powerful concept called the “payout ratio” to guide my decisions.
The payout ratio is the percentage of a company’s earnings used to pay its dividend. My rough rule of thumb is to stick with companies with a payout ratio of less than 60%.
You see, a company with a high payout ratio – one that pays out around 75% of its earnings as dividends – may struggle to maintain its dividend if it hits a rough patch or if the economy weakens.
Utility companies tend to have higher payout ratios. Often, it’s because they are mature companies with less room for growth. But even in this industry, I stay away from super-high payout ratios. They don’t provide a “cushion” for tough times.
However, 60% is a great “middle-of-the-road” number for investors interested in a safe payout AND some future growth.
You see, if a company has a payout ratio of less than 60%, it’s plowing 40% or more of the earnings back into the business, investing in its own growth. (A 2008 study showed 60% of the companies with a payout ratio of 60% or under raised their dividends down the road.)
To compute a company’s payout ratio, I divide the annual dividends per share by the annual earnings per share. I find both numbers in the company’s annual report. (For an even faster check, Yahoo Finance lists the payout ratio on its “key statistics” page.)
Here are a few of my favorite dividend-payers and their payout ratios…
As you can see, each company has a payout ratio well below 60%. They have plenty of money to both pay dividends and invest in their businesses. And earnings could theoretically fall in half before they’d have to think about cutting their dividends.
Even better, these are all companies that will grow earnings in good times and bad. And with their super-safe payout ratios, they’ll pass on that growth to you no matter what.
Here’s to our health, wealth, and a great retirement,