Dividend Death: Your Income Will Vanish If A Company Has This…

This post Dividend Death: Your Income Will Vanish If A Company Has This… appeared first on Daily Reckoning.

Here at The Daily Edge, we’re big fans of dividend stocks.

That’s because investing in companies that pay dividends is an excellent way to protect and grow your wealth.

Instead of relying on speculative stocks to trade higher (and risking big losses if the market pulls back), dividend stocks funnel cash into your account quarter by quarter — and sometimes month-by-month.

If you are using dividends to grow your retirement wealth, there is one metric that you must watch carefully.

Pay close attention to this metric, and your income will grow steadily. Ignore it, and you risk lower future dividends and a nasty decline in the price of your stock…

Introducing the Payout Ratio

A dividend stock’s “payout ratio” is a simple measure of how much of a company’s earnings are paid to investors through dividends.

Companies with a high payout ratio are passing on a large portion of each year’s profits to investors through dividends. On the other hand, stocks that have a low payout ratio are only sending a small portion of their income to investors.

As an example, consider a company that earns annual profits of $2.00 per share and pays a quarterly dividend of $0.25 (or $1.00 per year). This company would have a 50% payout ratio because it pays 50% of its profits to investors each year. The rest of the profits are either re-invested in new growth opportunities, or used for other purposes.

Most dividend investors prefer their stocks to have a high payout ratio.

After all, it makes sense to want a company to pay a large portion of their earnings to us as investors. We can then decide whether to use that cash to buy new shares, to invest in something else, or even to cover day-to-day expenses.

But as I’m going to show you today, there is a limit to how high payout ratios should go. And if you invest in a company with a payout ratio that is too high, you’re opening yourself up to a risky situation.

The Trouble With High Payout Ratios

Stocks that pay a very large portion of their earnings to investors through dividends are often much more risky than they appear.

At first glance, they may look like mature companies who are simply “taking good care of their shareholders.” After all, as the owner of the business (that’s technically what you are as a stock investor), you deserve a portion of the company’s profits.

But every business has challenging seasons. That’s the nature of free markets and the way our global economy works.

During challenging business seasons, profits can shrink. Companies may need more cash for projects that help them better compete against rivals. Or there may be excellent opportunities to buy other business lines that could boost profits over time.

Seasonal changes or opportunities emerge causing a company to need more cash, dividend payments could be in jeopardy. This is especially true if a company already pays out a large portion of its earnings to investors. After all, where is that cash going to come from if nearly all profits are already being paid through dividends?

In many cases, a challenging business environment will cause companies with high payout ratios to cut their dividend.

And when dividends are cut, it’s bad news for investors.

First of all, the income that you receive from this company will decline. If you’re counting on dividends to cover life expenses, you’ll need to find another source of income. You may even have to sell shares at a lower price to get the cash you need.

The second problem with stocks that cut their dividend is that shares prices usually drop. That’s because investors are not willing to pay as much to own a company that is cutting its dividend.

So investors are hurt not only by the loss of income, but also by the loss of capital as share prices drop.

That’s a bad spot to be in, and one that you can usually avoid if you pay attention to a stock’s payout ratio…

It’s All About Balance

So what should a company’s payout ratio be? Is there a magic number that investors should look for?

As with many things in investing (and in life), balance is key.

We want to own stocks that do pay us a material portion of their earnings. This way, we’re receiving a healthy return on our capital. But we don’t want the payout ratio to be so high that a company is likely to have to cut its dividend down the road.

It’s important to also look at the stability of a company’s earnings and its growth opportunities.

If a company is mature, with very stable earnings and few growth opportunities, a higher payout ratio is acceptable. That’s because it’s unlikely this stable company will have a pullback in earnings causing it to cut its dividends. And the company doesn’t need too much cash on hand for future growth.

A good example of this type of company is Procter & Gamble (NYSE:PG). This consumer staples company sells products that customers use every day. So profits are much more stable than for stocks in other industries.

On the other hand, a company with more ups and downs in profits and with growth opportunities should typically have a lower payout ratio. That’s because it’s likely that earnings will drop during challenging seasons, and a low payout ratio would allow a company to continue its business without cutting its dividend to investors. Also, keeping more cash on hand gives the company opportunities to spend money on growth opportunities.

A good example of this type of investment is Tesoro Corp. (NYSE:TSO). This crude oil refiner faces ups and downs in profits depending on commodity prices. The company pays an attractive $2.20 annual dividend. But that dividend only represents about 30% of next year’s expected earnings.

As a general rule, I watch closely if a company’s payout ratio is over 50%. And I start to get concerned if a company’s payout ratio is 70% or higher.

Remember, the higher a stock’s payout ratio, the bigger the chance that a company will have to cut its dividend during lean times.

A Word About Special Dividend Structures

You should consider a stock with a payout ratio above 70% to be in a “danger zone” and consider selling before the dividend is cut.

But there are two major exceptions to this rule:

Limited Partnerships — Companies with limited partnership structures (such as Master Limited Partnerships — or MLPs) are required to pay 90% of their operating earnings to investors. This rule automatically puts these companies above our “danger zone” threshold.

Real Estate Investment Trusts (REITS) — Similar to LPs, REITS are required to pay the vast majority of regular earnings to investors through distributions. So it is likely that most REITS you consider will have a very high payout ratio.

For these special types of investments, it is perfectly fine to own stocks with high payout ratios. Just keep in mind that these companies are more likely to cut distributions to shareholders during lean times because there is less of a buffer between earnings and normal dividend payments.

Of course this means it is even more important to analyze the REIT or MLP that you’re considering to ensure that profits are reliable. Also, I’m more likely to sell a portion of my REIT or MLP shares if I believe profits could be under pressure in the near future.

The bottom line is that dividend investors need to be very aware of their stocks’ payout ratio.

With this measure, “more” is not always “better.” Often, a bigger payout comes with higher risks to your long-term wealth.

Here’s to growing and protecting your wealth!

Zach Scheidt
Editor, The Daily Edge
[email protected]

Twitter: @ZachScheidt
Facebook: @TheDailyEdgeUSA

The post Dividend Death: Your Income Will Vanish If A Company Has This… appeared first on Daily Reckoning.

This story originally appeared in the Daily Reckoning . The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.