You know what a company's payout ratio is, right? It's the percentage of net income a company pays out to shareholders as a dividend. For example, Chevron (NYSE:CVX) is expected to earn $7.64 per share this year, and its annual dividend amount is currently $2.08. Divide $2.08 by $7.64 and you'll get 0.27, or a payout ratio of 27%. (Chevron's dividend yield was recently around 3.6%.)
So, is 27% good? Well, there is no exact, perfect payout ratio. But when the number is low, the firm is keeping more of its earnings for other uses, such as reinvesting them in the business or buying back shares. Think of Intel (NASDAQ:INTC) and its relatively low 34% payout ratio as an example.
When the number is high, the company is returning much of its earnings to shareholders with little left over for other purposes. If you're an investor seeking dividend income, that can be a good thing. It's not always good, though.
Consider pharmaceutical firm Bristol Myers-Squibb. With an annual dividend of $1.12 and earnings for 2006 expected to be $1.19 per share, the payout ratio is a rather uncomfortable 94%. (The dividend yield is approximately 4.6%.) There's little room for error here, and as our Motley Fool Income Investor newsletter analyst Mathew Emmert has noted: "The company has avoided a dividend cut thus far, but I continue to believe its payout is in peril. If the company loses the patent challenge on its blood-thinning medication Plavix, I think a cut is assured. Even if it receives favorable news on this front, the payout ratio will remain high."
For comparison in the pharmaceutical industry, Abbott Labs (NYSE:ABT) sports a payout ratio of 51%, while GlaxoSmithKline's (NYSE:GSK) is around 48%.
Beware of high numbers
There are many lessons to learn about dividends, and Mathew tackles them regularly in Income Investor. The examples above also offer a few. For starters, don't fall for the fattest dividend yield you can find. Because the yield is calculated by dividing the annual dividend by the current stock price, if the stock price falls, the yield rises. So a company in trouble may have a hefty yield -- at least until it reduces or eliminates its dividend.
Similarly, a high payout ratio is cause for concern. For example, the current annual dividend for Alaska Communications (NASDAQ:ALSK) is $0.86, and its price has recently been around $11.50 per share, giving it a quite attractive dividend yield around 7.3%. But its earnings per share for the past year are ... well, losses. And many analysts expect the company to lose a little money this year, too, before turning profitable in 2007. Do you see a problem here? How is this company expecting to pay out 86 cents per share when it's losing money each year? This isn't always an issue for a company -- it might rely on cash reserves or its cash flow picture might be better than earnings indicate due to accounting standards. But this is at least a red flag worth investigating.
Find the best bets
So choose your dividend-paying investments carefully, my friend. And if you'd like some help zeroing in on healthy, growing companies that pay significant dividends, give our Income Investor newsletter a whirl. You can try it for free for a whole month, with access to all past issues, special reports, and Mathew's complete list of recommendations -- the two newest of which are going to be released tomorrow. In two and a half years, Mathew's picks have averaged a return of 10%, vs. 7% for the same amounts invested in the S&P 500. As of the last time I checked, more than 20 of his picks sported yields above 5% and fully 14 topped 7%.
Here's to a hefty income in your future!
This article was originally published on May 3, 2006. It has been updated.
Selena Maranjian does not own shares of any company mentioned. GlaxoSmithKline is an Income Investor recommendation. Intel is an Inside Value recommendation. For more about Selena, viewher bio and her profile. The Motley Fool is Fools writing for Fools.
