Why A Low Payout Ratio Is Important

The payout ratio is an important metric to consider when analyzing a company and whether you would like to commit money to a position. Per Investopedia, the payout ratio can be defined as:

The amount of earnings paid out in dividends to shareholders. Investors can use the payout ratio to determine what companies are doing with their earnings.

Calculated as:

This sums it up pretty effectively. The payout ratio is basically a percentage of earnings paid out to investors in the form of dividends. A higher payout ratio means a company is paying out a higher percentage of their earnings to shareholders, while a lower payout ratio means a company is retaining a larger percentage of earnings to reinvest or grow the business. 

There are two camps on this. Growth investors, who like to make their money from capital gains, usually like to see very low payout ratios or no dividends at all. They usually like to invest in a company that is experiencing blistering growth and continues to reinvest earnings back into the company to fuel that growth. Companies like Apple (AAPL) and Netflix (NFLX) would fit this camp well. Dividend investors, or income investors, typically like to receive a percentage of a company's earnings in the form of dividends so that they can either reinvest those dividends as they see fit or cash out those dividends and pay bills with them. Companies like Procter & Gamble (PG) and PepsiCo (PEP) fit into this category. It's the choice and flexibility that dividends provide me that I really enjoy. Also, as someone who plans to retire early in life, I would prefer to have steady and consistent income with which to fund my lifestyle.

One of my entry criteria is that I like to invest in a company with a payout ratio of 50% or less. I believe that a low, or moderate, payout ratio leaves room for further dividend growth. The growth of the dividend is also one of my entry criteria, and is a cornerstone of my investment philosophy. I think with a payout ratio of around 50% you are getting the best of both worlds. You get the income, in the form of dividends, and you also get the growth from the retained/reinvested earnings that the company doesn't pay out to you. If a company is consistently paying out most of their earnings directly to shareholders it doesn't leave a lot on the table to grow the company and keep up that high payout ratio. What can I say? I like to have my cake and eat it too!

I think a 50% payout ratio is really a sweet spot for most dividend growth stocks. I think lower is also great, as that leaves a lot of room in the tank for large dividend increases in the future. Too low, however, and you get the sense that the company may not have a culture of being shareholder friendly. 50% of the earnings of a lot ofblue chip dividend growth stocks is still a lot of money, and it leaves a lot on the table to reinvest in the company and keep the growth moving in an upward direction.

What payout ratio do you generally look for?

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