I love hearing from my High-Yield Investing subscribers. Any time I get an email from a reader, whether it's in the form of a question, some constructive feedback, or simply a success story -- it reminds me that we've garnered quite the loyal following over the years.
One of the most common questions I get has to do with payout ratios.
The question usually goes something like this...
What is a dividend payout ratio?
Why do the dividend payout ratios listed in High-Yield Investing sometimes differ from the payout ratios I've found on various financial web sites?
These may sound like simple questions, but it's worth addressing for a wider audience.
Dividend Payout Ratio, Explained
The dividend payout ratio measures a stock's annual dividend payment as a fraction of its earnings. It tells you what portion of its earnings a company is paying out to shareholders. A company that earned $1 per share in profits over the past year and is now paying out 60 cents a share in annual dividends has a payout ratio of 60%.
When writing my High-Yield Investing newsletter, I take great care to list the most appropriate payout ratio for each particular security we mention. In many cases, we'll list payout ratios as a percentage of available cash flow instead of earnings. We calculate this data by reviewing each firm's latest annual financial statements.
Again, because earnings include a number of non-cash changes, including depreciation, the use of cash flow figures usually provides a more accurate indication of each firm's ability to continue to meet its dividend requirements. However, since we often use cash flow data instead of earnings, the payout ratios we reference in High-Yield Investing may differ from what you'll find on other financial web sites.
No matter how you calculate payout ratios, the general rule here is that the lower a stock's payout ratio, the better. The reason for this is simple -- firms with low payout ratios generally have more room to raise their dividend payments in the future. Low payout ratios also provide an extra level of security because even if the company's earnings were to decelerate, the dividend would remain safe for a period of time.
Bottom line, it's important to understand payout ratios: what they are, how they're calculated, and what's considered a high or low payout ratio. Not only does it explain some of the discrepancies you'll find from different information sources, but it can also make a huge difference in determining whether an investment is right for you when the time comes to decide whether to buy or sell.
(This article originally appeared on StreetAuthority.com.)