The Truth About Dividend Payout Ratio

While dividend investing is a great way for investors to get a steady stream of return through income from their stock purchases, there are still certain signs that need to be examined to make sure an investment is a smart one. One important metric to measure the reliability of a dividend stock is the dividend payout ratio.

Payout Ratio Basics

The dividend payout ratio is used to examine if a company's earnings can support the current dividend payment amount. The statistic is determined by dividing the annualized dividend per share paid out by the full-year earnings per share ( EPS ) of the company. If a company has a dividend payout ratio over 100% then that means that the company is paying out more to its shareholders than earnings coming in. This is typically not a good recipe for the company's financial health; it can be a sign that the dividend payment will be cut in the future.

An example of the instability of a dividend payout ratio over 100% is from professional wrestling and entertainment company World Wrestling Entertainment ( WWE ). After a consistent period of dividend payout ratios over 100%, the WWE had to cut its quarterly dividend payment from 36 cents per share to 12 cents per share in June of 2011. The company's financials could not justify a dividend payout ratio of about 182% at the time when its future financial outlook was bleak. Even after the dividend cut, the WWE dividend situation continues to show concerns. The firm currently has an annual dividend payout of 48 cents per share and an EPS of 29 cents. This equates to a dividend payout ratio 160%. This should concern investors and illustrates how dividend payout ratio can be used to measure the benefits of an investment.

Always Look Ahead, Never Behind

However, to determine the viability of the dividend payment, a company looks towards future earnings, not previous ones. Since companies look at future earnings expectations to determine their dividend policy, shouldn't we investors do the same?

This forward-looking strategy can make a backward-looking dividend payout ratio seem bloated, but in actuality the financial situation will be able to support the payout level without a problem. For example, telecommunications giant AT&T ( T ) currently has an annual dividend payment of about $1.76. However, its 2011 earnings (the last reported full year) were 77 cents per share. That means that the firm has a backward-looking dividend payout ratio of around 230%. This figure is obviously alarming at first. But if the current earnings outlook for AT&T in fiscal year 2012 (approx. $2.39 per share) and 2013 (approx. $2.59 per share) are examined it can is easy to see that AT&T expects that its dividend is easily sustainable for the future. Also, AT&T has a tremendous history of dividend payouts, increasing its yearly dividend for 29 straight years. Clearly, investors need to do examine more than just the surface of these key statistics to determine if an investment its an intelligent one.

Not All Ratios are Created Equal

As the above examples depict, the dividend payout ratio will be different for different firms in different industries with different financial situations. Investors need to realize that not all companies' dividend payout ratios should be examined the same. Typically older and more mature companies will tend to have a higher payout ratio as they have the financial capabilities to payout more to shareholders. Also, some companies, especially new ones, will prefer to have a lower dividend payout ratio in order to retain earnings that can be utilized for future company growth. The more mature, established companies do not focus on such growth, so they will be more willing to pay the higher dividends. Investor need to know whether a potential investment is a growth stock or a dividend stock in order to properly comprehend its dividend payout ratio.

There are even times when investors should ignore dividend payout ratios all together, as certain companies will always have unusually high numbers. The payout ratio should not be applied to MLPs, Trusts, or REITs as they have a unique financial structure and are obligated to pay out most of their earnings as dividends. Firms under these classifications will always pay a high percentage of their earnings towards dividends.

The Bottom Line

Investing in dividend stocks is a great way to diversify portfolios and use as a source of extra income. However, simply throwing money into stocks with high yields or high payouts may not always be the right answer to an investor's goals. Dividend payout ratio is a great statistic to show whether the potential investment can keep paying the lucrative dividend amounts now and for the years to come. Examining this metric can help realize future returns through both dividend payments and capital appreciation.

Be sure to visit our complete recommended list of the Best Dividend Stocks , as well as a detailed explanation of our ratings system here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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