Why you are looking at the dividend payout ratio all wrong

Investors love dividends and rightfully so! What is not to like about tax efficient distributions that come in on a regular basis while the investor does nothing and often even grow over time? There are various benefits to a dividend, between the ability to reinvest the cash flows, utilize dividend reinvestment plans (DRIPs), keep management honest (need to manage cash flows responsibly) and being a ‘bird in the hand’ when it comes to returns. Since dividends are so important when it comes to total returns of stocks, it is no wonder that the payout ratio (ability of a company to fund the distribution) is such an important metric to understand. Unfortunately, this ratio is likely one of the most misunderstood and misreported metrics out there, even more so than the P/E ratio. Throw in the fact that companies make adjustments all the time to calculate their own payout ratios and it is easy to see why it can become so convoluted.

Why is the payout ratio so important?

For investors that own dividend companies, the payout ratio is important because it shows the ability to cover the dividends on a sustainable basis. A payout of 50% means that 50% of funds go toward the dividend. A ratio of 100% means all funds are directed to the dividend and a ratio above 100% means that all of the funds are directed to the dividend and also that the company likely relies on financing/liquidity (through cash balances, asset sales, debt, or share issues) to fund the payout. Obviously, a payout above 100% would be unsustainable over the long-term and the closer to 100% the ratio is, the less ability the company has to absorb any economic slowdown. Higher ratios also mean that less funds are being reinvested into the company and in turn into growth. Put simply, the payout ratio is important because it helps an investor understand how reliable a distribution is over the long term. We do want to note, however, that there is no such thing as a ‘safe’ dividend. Companies have no obligation to pay these and can cut them at a moments notice. These are usually the first things to go when times get tough.

Why most people are using the ratio wrong:

Since the payout ratio can be calculated in different ways, data services usually go with the simplest calculation, which is dividing the dividend by earnings per share (EPS). So if we have an annual dividend of $1 and EPS of $3, the payout ratio is equal to 33% (1/3).  In other words, out of company earnings, 33% of the earnings go toward the dividend. This way of calculating the payout is the easiest and most conservative way to approach distributions but it also leads to investors passing on attractive investment opportunities with strong yields simply because they are using the wrong denominator in the form of EPS. Since dividends are paid out of cash flows, and earnings per share involves non cash deductions (the biggest of which is depreciation), a companies ability to pay a dividend is often much better than what a payout calculated off of EPS usually implies.  For companies with lots of capital expenditures, using EPS can actually be dangerous as it dos not reflect the expenditures the company is making. Another reason using this payout ratio can be inappropriate is due to the volatility of EPS. If a company has a large write-down or some other one-time expense, the data service an investor looks at will likely show a ratio way above 100%. Again, this would often lead to an investor ignore an investment opportunity that very well may fit their needs. 

The long and short: Dividends are paid out through cash flows not earnings, so calculating the ratio off of earnings is not the most appropriate and can lead to missed opportunities. Most data service will calculate the ratio through EPS due to simplicity.

Operating cash flows – A step in the right direction:

While still not ‘perfect’, we think using operating cash flows (OCF) instead of EPS is a much better approximation of the sustainable payout ratio. It captures all of the items that EPS captures (OCF begins with net income then makes cash based adjustments) while still being a relatively simple metric to obtain and apply. Instead of using EPS from the income statement, an investor need to go to the cash flow statement instead and use the OCF value provided. Depending on how the company in question breaks their financials down, one extra step of dividing OCF by shares outstanding (to obtain a per share value) may be required. Once OCF per share is obtained, the calculation of the payout ratio is the same simple formula: Dividends/OCF = Payout ratio.

In order to understand why the use of operating cash flows is better, we need to dig a bit into what operating cash flows are. Essentially, a company’s OCF takes the net income value and then adjusts for any non-cash charges. Remember, dividends are paid out of cash flows, which is why it makes sense to remove accounting charges such as depreciation. The two largest adjustments that are usually seen are changes in working capital and depreciation, with depreciation usually being the biggest. This is even more important when considering capital-intensive companies such as pipelines, as depreciation charges can be very large but are not actually any drain on cash in the current period. Those who use EPS in calculating payout ratios would view the distributions of many of these companies as high risk but simply adding depreciation charges back paints a much more realistic picture of the company’s ability to fund a dividend in the short to medium term.

We will use Rogers Sugar (Ticker: RSI), a classic high-yielder in Canada, as an example:

In 2015, RSI paid dividends totaling $33.86 million. RSI had net income of $24.03 million and operating cash flows of $55.49 million (after adding back depreciation charges of $12.72 million and non-cash charges of $26.78 million). If we were to calculate the payout ratio off of earnings, we would get a value of 141%! However, when using operating cash flows, we get 61%, a much more manageable value and would lead to a very different conclusion.

Since using OCF is still a shortcut on calculating a payout ratio, it is important to remember that in a lot of cases the depreciation represents assets that need to be replaced (with cash purchases) at some point in time. Fortunately, this is often years down the road and the company can build its excess cash flows in cash or tap credit to replace assets. OCF also does not account for capital expenditures being made by a company, which is where we are going in the next step. While not perfect, we do believe OCF is still a much better metric to use in a payout ratio compared to EPS and still balances simplicity and time resources required with the calculation.

The long and short: OCF is a better match to what funds a company actually has coming in to the cash outflows required to fund a dividend. It is still not perfect but a step in the right direction.

The CFA way – Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE):

This is the most comprehensive way to calculate payout ratio and dividend sustainability for a company. It is time consuming and requires a bit of an understanding of financials, but hopefully we can sum it up in an easy to understand way. While it takes a bit more work, if one has calculated the payout ratio based on OCF and is still not comforted by what they see, this step could save a lot of grief and sleepless nights.

FCFF = CFO + (Interest charges * (1 – tax rate)) – CapEx

FCFE = CFO –CapEx + Net Borrowing

            Net Borrowing = Debt paid + Debt raised

The difference between the two calculations is a matter of point of view. FCFF takes the point of view of the funds available to the whole company before any capital structure decisions are made (such as paying down debt vs dividends). Meanwhile FCFE looks at funds available to equity holders only, after capital structure decisions such as debt financings are made. The differences are a bit nuanced but we prefer FCFF over FCFE. This is simply because FCFE includes net borrowing and since a company cannot continually add debt to the balance sheet, including the borrowing of debt as a source of sustainable cash is unrealistic, in our view. Essentially, a company that added a good deal of debt each year could show a payout ratio below 100% even though the only reason they are able to pay the dividend is due to debt being added. If financing was no longer available, the dividend could then be at risk. For those looking for a shortcut here, in a lot of cases, one could exclude the after tax interest charge calculation as the impact is likely to be small relative to the others. Obviously, if the company is highly levered, it should be considered.

The big step that is made from the OCF calculation to the FCFF/FCFE calculation is that of CapEx. For companies that are investing heavily in growth or are capital intensive, taking this extra step will be important. For companies that do not have a whole lot of capital expenditures, using OCF is probably going to meet your needs. Capital expenditures are what a company pays for plant and equipment. This can be broken down into two types: Growth and maintenance capex. Growth would be things like acquisitions and new plants. Maintenance pertains more to the ongoing costs required to maintain operations and keep things running smoothly. This is another area where there is some nuance as some will include all capex while others will just look at maintenance. Again, there is no right answer and the distinction is likely not to matter for most individuals purposes 90% of the time.

The long and short – FCFF and FCFE are the most appropriate ways to look at payout ratios and dividend sustainability. Some shortcuts can be made in favour of the KISS principle while still meeting the needs under most circumstances. If the OCF payout ratio is below 75%, going this extra step to determine dividend sustainability is likely (but not always) unnecessary, as a company doesn’t have to do capital expenditures each year.

If you got through this post so far, congratulations! You have just provided yourself with a tool that will not only allow you to consider stocks that were maybe ignored initially but also help screen out ones that are at risk. This also helps an investor look past management provided payout ratios that are often full of adjustments that can be confusing and at times inappropriate.  We have also put the payout ratio calculations into practice by looking at real companies with different payout strategies, so be sure to sign up for the blog below so you are notified of when we put it up.

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