Dividend payout ratio – and why it’s more important than a high dividend yield

If you love income stocks that pay a high dividend yield, then you ought to know about this one important ratio – the dividend payout ratio.

The dividend payout ratio is the percentage of a company’s profit that is paid out as dividends to shareholders. For example, if a company earns one million in profit and pays $500,000 as dividends, then its dividend payout ratio is 50%.

The dividend payout ratio can also go above 100%. So if a company earns a million and pays out $1.2 million, its ratio is 120% — which essentially means it paid out more than it earned in a given year. In the long run, a dividend payout ratio above 100% is not sustainable.

As an income investor, we want to invest in stocks that can pay a steady or growing dividend — even during a recession. The 2008/9 Global Financial Crisis was one of the worst recessions in recent history, but it was also a great time to evaluate which stocks were resilient enough to maintain a steady dividend during a crisis. In other words, a company that can maintain or grow its dividends in good or bad times is a great income stock.

A second chance at dividends?

Some years ago, I remembered that Second Chance Properties was widely touted as an income stock that paid a very attractive annual dividend yield between 8% to 10%. Not only that, Second Chance was one of the few stocks that increased its dividend per share (DPS) by 16.7% from 2.4 cents to 2.8 cents in 2009 — right in the middle of the Global Financial Crisis!

Second Chance Properties Dividend Per Share (2007-2013)

Due to its impressive track record and high yield, this stock naturally attracted many income investors. So let’s say you invested in Second Chance in 2013, you’d be happy to know that your DPS grew further to 3.5 cents in 2014 and then 3.6 cents in 2015 — which translated to a hefty 8.5% dividend yield.

Over the next two years, however, you’d find yourself very disappointed with Second Chance founder and CEO Mohamed Salleh — not because of his failed Singapore presidency bid in 2017 — but because Second Chance cut its dividend by more than 90% in 2016 and 2017.

Second Chance Properties Dividend Per Share (2011-2017)

Normally, such a sharp fall in dividends is often accompanied by a substantial fall in earnings. But Second Chance’s EBITDA (earnings before interest, tax, depreciation and amortisation) only decreased marginally by 3.3%.

So what caused Second Chance’s massive drop in dividends? It was its unsustainably high dividend payout ratio.

*Income from fair value gain/loss from investment properties and financial assets are excluded as these are one-off items.

As you can see, Second Chance’s payout ratio for three years, from 2012 to 2014, were far above 100%. Such a high dividend payout ratio is a red flag for savvy investors because it is unsustainable in the long run. But a less experienced one would have probably skipped this and been tempted by the high dividend yield on offer.

Do note that it is important to remove any exceptional items that are one-off in nature and may distort a company’s earnings and, hence, its dividend payout ratio. When there’s a one-time gain, this artificially inflates a company’s earnings and thereby lowers its dividend payout ratio (when it should be higher). Similarly, a one-time loss deflates earnings and raises the payout ratio (when it should be lower).

For example, I removed Second Chance’s one-time gain of nearly $3.4 million in 2014 to calculate its dividend payout ratio for the same year. (And it was still above 100%!)

Source: Second Chance Properties 2015 annual report

The fifth perspective

Using a stock filter tool, here is a non-exhaustive list of SGX and Bursa Malaysia stocks that had payout ratios above 100% in 2017:

If you plan to buy (or already own) any of the stocks listed in the table above for its dividend, you don’t have to panic, but you might want to check on its dividend payout ratio and exceptional items. The thing with many stock filters is that they usually include exceptional items, which will distort the dividend payout ratio. There is no hard and fast rule for which item is exceptional or not, but if it is one-off in nature and highly unlikely to happen again, I would remove it.

So by simply checking a stock’s dividend payout ratio, you can avoid companies with high, unsustainable ratios — and focus only on the ones with a steady dividend and reasonable payout ratios.

Looking to invest for dividends? Dividend Machines 2018 is opening 26 Feb. Watch for it here…