Wall Street’s Best Editor’s Notes: This article is an excerpt from Charles A. Carlson’s DRIP Investor. For almost a quarter of a century, Chuck has been informing and educating investors interested in systematic monthly investing via Dividend Reinvestment Plans. In this article, he discusses the importance of a low dividend payout ratio to a company’s future health, and presents a few of his favorite stocks.
One of the best indicators of a company’s dividend health is the payout ratio. The payout ratio looks at the percentage of profits a firm is paying out to shareholders in dividends. For example, a firm that is expected to earn $3 per share in profits in 2016 and pays dividends at an annualized rate of $1 per share has a payout ratio of 0.33, or 33% (1 divided by 3). As you can tell from this example, the higher the payout ratio, the greater the portion of profits the firm is paying out in dividends.
The payout ratio provides a quick snapshot of the cushion the firm has to maintain and increase its dividend. A company with a payout ratio of 1.0 is paying out all of its profits in the form of dividends. Such a dividend policy has its risks, especially if profits decline. To be sure, there are some firms with a payout ratio above 1.0, meaning they are paying out more money in dividends than they are generating in profits. Such firms may borrow money to fund the dividend.
However, if a company is consistently paying more in dividends than profits, the dividend will eventually be cut or omitted. Conversely, companies that are paying out a small percentage of their profits in dividends have room to expand their dividend, especially if the bottom line is advancing.
S&P 500 companies have paid out roughly 38% of their profits in dividends over the last 12 months. That 38% payout ratio is similar to the 38% ratio recorded in 2009, when earnings were down dramatically as a result of the financial crisis. The payout ratio in the S&P 500 has been creeping higher over the last five years as a result of dividends growing faster than profits and dividend cuts accelerating in the energy sector.
The increase in the payout ratio could pinch dividend growth in the near term unless earnings growth catches up. For that reason, investors who seek dividend growers should pay special attention to the payout ratio. I get nervous when I see non-utility stocks with payout ratios of 70% or higher. And it is unlikely that firms with payout ratios above 50% will show more than modest dividend expansion over the next few years.
Low Payout Ratios, Growing Dividends
The above table lists eight stocks with payout ratios below 30%, dividend yields of at least 1%, and expected earnings growth in the current fiscal year of at least 5%. The combination of earnings growth and below-average payout ratios should lead to dividend increases of at least 5% over the next 12 months. Please note all of the stocks on the list offer direct-purchase plans whereby any investor may buy the first share and every share directly from the company.
Among the stocks listed here, I think media stocks Walt Disney (DIS) and Scripps Networks Interactive (SNI) are especially attractive values. Southwest Airlines (LUV), which recently received approval to begin routes to Cuba, has been roughed up of late and is offering good value for patient investors. S&P Global (SPGI), a data and analytics firm, also has near-term appeal.
Wall Street’s Best Editor’s Comment: Of these four companies, three beat analysts’ estimates last quarter (SNI, SPGI, and LUV); and three analysts for SNI recently increased their earnings forecasts for the company.
Charles A. Carlson, CFA, DRIP Investor, 800-233- 5922, June 2016