The shrinking payout ratio

Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends. That is, the payout ratio is the dividends divided to total earnings. Some investors prefer a low payout ratio as it indicates that a large portion of earnings is left in the company where it can be invested for future  growth. A low payout ratio can also indicate that the dividends are safe from cuts even if the earnings were to shrink.

A low payout ratio, however, can be a problem if it is an indication that the profits are squandered in unproductive activities and not used for rewarding the owners. As an example of unproductive activities, a company with a low payout ratio might use the profits for overpriced acquisitions or overly generous management compensation. 

It is interesting to look at the development of the payout ratio of the SP500 index over the past century. As is shown in Figure 1, the payout ratio has been slowly and steadily declining which means that the owners today receive a smaller share of the profit than in the past.

Figure 1: Historical dividend payout ratio for SP500.

The low payout ratio is sometimes explained by the stock paybacks that have been in fashion lately. This explanation is easy to disprove: If the stock paybacks were significant, they would reduce the number of  shares outstanding and the earnings and dividend per share should increase accordingly. As seen in the long term development of the dividend growth, the earnings and dividend growth have not been accelerating. In fact,  the dividend growth has been lacking lately.

Given that SP500 companies as a whole do not make it a priority reward their owners, perhaps a KISS investor should focus on dividend paying companies with a track record of rewarding owners. In this perspective, the high payout ratio is not a problem if it is backed with a high dividend yield and a dividend growth rate.

Comments