Dividend yield and payout ratio: how to judge a dividend

Dividends are a share of a company's profits paid out to shareholders. They can make up an important part of the total return from owning shares, and many investors rely on them for income. But not every dividend is safe, and a high yield can be a warning rather than a reward. This article explains the key measures, shows how to test whether a dividend is sustainable, and describes common traps.

How dividends work

A company's board decides whether to pay a dividend, how much, and how often. Payments are commonly made quarterly, though some pay semi-annually or annually. There are several important dates:

• Declaration date: the company announces the dividend.
• Ex-dividend date: you must own the share before this date to receive the dividend. On this date, the share price typically falls by about the amount of the dividend, since the cash has left the company.
• Record and payment dates: when the owner is recorded and when the cash is paid.

Dividends are never guaranteed. A board can reduce or cancel them at any time.

Dividend yield

Dividend yield equals the yearly dividend per share divided by the share price. If a share costs 50 and pays 2 a year, the yield is 4%.

The yield changes whenever the price does. If the price falls from 50 to 30 and the dividend stays at 2, the yield rises to about 6.7%. This is why an unusually high yield can be a warning. It may mean that the market doubts the dividend will be maintained.

Payout ratio

The payout ratio is dividends divided by earnings. If earnings per share are 4 and the dividend is 2, the payout ratio is 50%. It shows how much of its profit the company is distributing, and how much it keeps to reinvest or to absorb a bad year.

• A low to moderate payout ratio leaves room for the dividend to grow and a cushion if profits fall.
• A very high ratio, near or over 100%, means the company is paying out all or more than it earns, which is hard to sustain.

Acceptable levels differ by industry. Utilities, telecoms and real estate investment trusts typically pay out a large share of profits by design. Growth companies pay little or nothing and reinvest instead.

Look at cash, not just earnings

Earnings can be affected by accounting items. Check whether the dividend is covered by free cash flow. If a company pays 100 in dividends and generates 120 in free cash flow, the cash payout ratio is about 83%, so cover is thin. If free cash flow is 200, there is a comfortable margin. A dividend that is paid out of borrowing or asset sales cannot last.

Other checks of sustainability

1. Track record. Has the company paid and grown its dividend through past downturns? Some companies have raised dividends for decades, but past behaviour does not guarantee the future.
2. Debt. A company with heavy borrowing must prioritise lenders over shareholders if times get hard.
3. Earnings stability. Businesses with steady demand are better able to maintain payouts than cyclical ones.
4. Growth prospects. A dividend that grows with earnings is stronger than one held up by a shrinking business.
5. Capital needs. If the company needs to invest heavily, a large dividend may compete with that.
6. Management's stated policy. What does the company say about its dividend and priorities?

Dividends versus buybacks

A company can also return cash by buying back its own shares, which reduces the number of shares and increases the share of profits attributable to each remaining one. Some investors look at shareholder yield, which combines dividends, buybacks and debt reduction. Buybacks are flexible, since they can be paused without the signalling cost of cutting a dividend, but they only create value if shares are bought at reasonable prices.

Dividend growth

A modest yield that grows steadily can deliver more income over time than a high, static one. A company that grows its dividend by 7% a year doubles it in about ten years. This is also a sign of a business that is growing its earnings. However, do not pay a high price for a dividend record alone.

Taxes and reinvestment

Dividends may be taxed differently from capital gains, and the treatment depends on your country and account type. Foreign dividends can face withholding taxes. Many brokers offer to reinvest dividends automatically, which can help compounding. Check the rules and costs that apply to you.

Yield traps

A yield trap is a stock whose high yield results from a falling price and which is likely to cut its dividend. Typical warning signs are a payout ratio above 100%, declining earnings or cash flow, rising debt, and a share price falling much faster than the market. When the cut comes, investors lose twice: the income drops and the share price usually falls further.

Common mistakes

• Chasing the highest yield.
• Judging a dividend on the yield alone.
• Ignoring the payout ratio and cash coverage.
• Overlooking the debt level.
• Concentrating in a single high-yield sector.
• Forgetting that dividends are paid from the value of the company, and that the share price falls when it pays them.

A short checklist

• I have checked the yield, the payout ratio and the free cash flow cover.
• I know the history of the dividend, including any cuts.
• I have looked at debt and earnings stability.
• I understand how the dividend is taxed where I live.

Dividends are never guaranteed and can be cut at any time. Judge the business behind the dividend, not just the yield on the screen.