Source: Flickr user Alan O'Rourke.
Investors are realizing the power of dividends and are eager to add dividend payers to their portfolios. But not all dividends are the same, and if you want to be a better dividend investor, you need to understand the dividend payout ratio.
Power of dividends
First, though, understand the remarkable power of dividends. A Morgan Stanley study found that 42% of the S&P 500's return from 1930 to 2012 resulted from dividends. Also, according to Jeremy Siegel's research in Stocks for the Long Run, the quintile of stocks in the S&P 500 with the highest dividend yields performed best between 1957 and 2012, averaging annual growth of 12.6% versus 10.1% for the overall index.
If that doesn't seem like a huge difference, consider that a $100,000 portfolio will grow to $1.1 million over 25 years at 10.1% but $1.9 million at 12.6%.
The best dividends
So how do you find the best dividends? Obviously, high dividend yields are generally preferable to low yields. Note, though, that some very high yields are the result of a deserved slump in the share price. This is because a dividend yield reflects a stock's annual dividend divided by its stock price. If the stock crashes, the yield will shoot up. Therefore a high yield alone is not a sufficient buy indicator.
It's also important to consider how rapidly a dividend has grown, as companies in good shape tend to increase their payouts regularly. A 3% dividend yield might look less attractive than a 4% yield, but if the 3% dividend has grown by an annual average of 15% over the past few years, while the 4% dividend has grown by 4% per year, the lower payout will soon surpass the higher one.
Finally, consider the company itself. You might find a significant dividend that has been hiked rapidly over the past few years, but if the company is saddled with heavy debt or is faced with falling revenue and earnings, then its dividend is in danger of being reduced or suspended. Favor healthy and growing companies with competitive advantages and rosy futures.
The dividend payout ratio
One signal of whether a dividend is sustainable or not is the dividend payout ratio, which reflects the portion of the company's earnings that are spent on dividends. If it's more than 100% -- or even reasonably close to 100%, say, 85% -- then the company may eventually be unable to meet its dividend obligations.
A steep dividend payout ratio isn't necessarily a deal breaker, because a company's earnings might simply be temporarily depressed and might be expected to grow rapidly soon. But a payout ratio in the range of about 30% to 60% is good, because it shows a significant commitment to dividend payments and also plenty of room for payout increases. Even 80% is not necessarily worrisome.
You calculate the dividend payout ratio simply by taking the annual dividend sum and dividing it by the company's earnings per share over the trailing 12 months. Consider fiber-optic and glass specialist Corning (GLW -0.03%) as an example: Its quarterly dividend is $0.10, for a total of $0.40 annually, and its trailing 12-month EPS is $1.33. Divide $0.40 by $1.33, and you get 0.3, or 30%, for Corning's dividend payout ratio.
Source: Altria Group.
Consider tobacco titan Altria Group (MO 0.12%) next. The company has long paid generous dividends and has been favored by dividend investors. The stock has averaged a 30-year annual return of 20%, and its yield was recently above 4%. That all sounds great, but take a gander at the dividend payout ratio, which was recently about 97%. A decade ago it was close to 60%. This is a red flag and has led to worries about the dividend's future. Still, the company's payout ratio target is 80%, and it offers many reasons to be hopeful about its future despite a shrinking smoker base in the U.S. For example, Altria's powerful brand can command premium prices, and the company is moving into electronic cigarettes, too.
When you hunt for great dividend stocks, be sure to pay attention to the dividend payout ratio, as it can give you a rough idea of the health of the dividend.
