This is a somewhat complicated subject which I have avoided putting in an investment tip. But it’s an important one, so I’m going to try to give the Cliff Notes version.
One of the primary reasons to own a stock is because of dividend payouts. It’s really the thing that makes you feel like you own an actual business, not just a piece of paper. You as a company owner are receiving part of the profits every quarter as a dividend.
The single most important question to ask about a company’s dividend is, can they continue to pay it going forward? The ratio that gives you a basic sense is the Dividend Payout Ratio. That tells you how much of the companies net profits are going to toward the dividend. If only 30% of the companies profits are being paid toward dividends, it’s probably pretty safe. 90%? A dividend cut does become more of a possibility.
But only a possibility. There are many reasons that a dividend payout may be extraordinarily high for a year or two. A large non-cash depreciation expense can hurt net earnings, but not really affect how much the company can pay in dividends. Another issue is the type of business. Real estate investment trusts and business development company (REITs and BDCs) are required to pay out 90% of their profits as dividends. With REITs in particular, it may actually exceed 100% of net earnings. REITs use a different measure, FFO to determine how much of their profits they can payout in dividends.
So to determine the safety of a company’s dividends, I recommend a 3 step process:
- Look at the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) compared to the dividend. If it’s not covered then, it can be a warning sign.
- Examine the company’s dividend history. If they have consistently paid dividends, and even increased them, it’s a sign the company will try to continue the payout.
- Read what the company says about dividends. In their financial statements some companies will state that they intend to continue paying dividends, while others will provide little assurance. Listen to what the company says.
As I said, a complicated subject. But dividend payouts are a very important part of many stock purchases, and should be analyzed with care.