Welcome to part III of my series examining the attributes of good dividend stocks.   When buying a stock for income, the safety of the dividend is of utmost importance.  Dividend cuts are frowned upon because they amount to an admission of defeat by management and show a lack of confidence in the executive suite about future earnings.  Investors usually brutally punish companies that cut their dividend by dumping their stock.  The dividend investor thus suffers a double whammy: a severe decrease in income coupled with a large drop in the stock price.

The Importance Of A Low Payout Ratio

According to investopedia, the dividend payout ratio is merely the yearly dividend per share divided by earnings per share.  In general, the higher the payout ratio the greater the danger of the dividend being cut.  A company paying out 80% of its earnings in dividends every year is in trouble if earnings should drop 20%.  In that case, management will likely have no choice but to either cut the dividend or take on significant debt in order to sustain it, both of which bode poorly for future earnings and thus dividend growth.  If, on the other hand, a company paying out only 20% of earnings hits a rough patch and sees its earnings decline, there is a very good chance management will be able to maintain the current dividend rate.

Low Payout Ratios Leave Room To Grow

In general, corporate management only pays out excess cash it can’t reinvest in the company at a reasonable return out as dividends.  A high payout ratio amounts to an explicity admission by management that future growth prospects are limited.  A company paying out 80% of its earnings as dividends doesn’t expect to grow quickly in the future.  If it did, management would reinvest that cash back into the company instead.  Because of this, buying stocks with extremely high dividend yields is unlikely to pay out the greatest dividend income over time because they will have a hard time increasing dividends by much more than the inflation rate over the long run.  Most income investors with a long time horizon would be better off investing in stocks with moderately above-average dividend yields but with the potential for significant dividend growth over time.  Below I’ve calculated the yearly dividend rates of two hypothetical $100,000 dividend stock investments.  Stock A has an initial yield of only 3% but raises the dividend by 10% per year over the long term.  Stock B, on the other hand, has a large initial yield of 7% but is only able to raise the dividend in line with inflation every year, or around 3%.  Let’s see how they perform over a 40 year holding period.

 As you can see, the lower-yield, high-growth dividend stock begins paying out a higher yearly dividend around the 11th year of ownership.  By year 40, stock A pays out a full 161% of your initial investment in dividends every year.  Stock B, on the other hand, pays out only 23% of your initial investment.  Not a bad return certainly, but it’s obvious which stock you’d want to own.

The State Of The Market

Currently, the S&P 500’s payout ratio stands near historic lows at around 30%, mainly because earnings have been increasing more rapidly than dividends in the recent past.  This means dividends have a lot of room to grow in the future.  As a general rule, dividend paying stocks with a payout ratio of less than 50% and growth rate of at least 10% make the best long-term income investments

Attributes Of A Good Dividend Stock

Please read the rest of the series

• Introduction: The Case For Dividends
• Part II: A History Of Rising Dividends
• Part III: A Low Payout Ratio
• Part IV:  Free Cash Flow And The Dividend Coverage Ratio 

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• Attributes Of A Good Dividend Stock
• Free Cash Flow And The Dividend Coverage Ratio: Attributes Of A Good Dividend Stock
• A History Of Rising Dividends: Attributes Of A Good Dividend Stock