Today I came across a post from a fellow blogger MMD and his article on his blog “Using the Dividend Payout Ratio to Help Evaluate Stocks“. The author is writing about looking at the payout ratio of dividend paying stocks and evaluating their ability to sustain their dividends or even their financial strength and profitability in the future.

His reviews came up based on an article in Money Magazine. I haven’t read the article in the magazine, but from my fellow blogger’s post it is apparent that even the authors of the article in the magazine are wrong in using payout ratio metrics to evaluate a stock.

My post shall not be, by any mean, considered as a criticism, but rather an explanation of what misconceptions beginning investors are falling for and as is clear from my fellow blogger’s post, even so called professionals do the same mistake.

There are many aspects you should take into consideration when looking at payout ratio, but in this post I will look at two of them only. One is probably very widely known (although the Money Magazine seems to be making that mistake too) and the other one is less known.

What Is Payout Ratio

Before I dig deeper into the proper look at payout ratio, let me quickly review, what payout ratio is. The definition is a percentage of dividends paid out compared to earnings the company makes. The equation of payout ratio is as follows:

Dividend Payout Ratio = Dividend Per Share [DPS] / Earnings Per Share [EPS]

Now that you know what dividend payout ratio is, let’s take a look at two common and deadly misconceptions. Why deadly? If you fall for those traps, you get rid yourself from juicy profits in the future.

Comparing Companies Across The Board

First mistake investors typically do is comparing companies across the stock universe. Don’t think that I was a genius from the beginning. No, I was doing the exact same mistake in my investing past.

As is true with any other metrics such as P/E ratio, PEG, and others it is a wrong approach comparing two companies and their payout ratios from a different industries. The fellow blogger uses an example from Money Magazine comparing McDonald with AT&T stating MCD‘s payout ratio to be 54% and AT&T ratio to be 144%. A commenter William posting his comment under the mentioned article even ads Annaly to a pool for comparison.

In my opinion it is a serious mistake comparing two different companies and different sectors or industries. It is not possible to compare REITs and their payout ratio with Telecommunication services or Consumer Discretionary as they have totally different requirements. For example REITs are required to pay out 90% or more of their earnings (which is called distribution and not dividends) to the shareholders. MLPs have similar requirements. Thus you will rarely see RETs or MLP with ratio at 70% or less. Most likely the ratio would be around 200%.

Unfortunately, I have seen many advisers and well known brokers providing an advice to their clients that they should be picking stocks with payout ratio at 60% or less. Some at least add that some sectors are OK with higher payout ratio.

Never compare ratios between different companies. If you still want to do the comparison, do it for at least among the companies in the same sector or industry, ideally among the company’s peers only. In my opinion it makes no sense comparing companies’ payout ratio whatsoever.

Put Payout Ratio In Proper Context

The second serious mistake investors do when evaluating the payout ratio is not that widely known and I have seen many of them not knowing how to look at this metrics from the proper perspective.

To demonstrate the mistake investors do I will use AT&T as an example. As my fellow blogger states, you do not have to calculate the payout ratio manually. Just go to Yahoo! Finance and there you can easily find it.

To do so, you can find that as of this writing AT&T has a payout ratio of 144%. You may then question the company’s dividend policy and consider AT&T at the verge of dividend cut, financial sustainability and company to avoid.

Well doing so you would dump a good company which was increasing it’s dividend for 8 consecutive years and has a great prospect of continuing so.

The only reason, why you do not see the real value is that you are looking at the ratio from the wrong perspective. If you go back to the top of my post to see how the ratio is constructed, you will see that it is made of dividend rate per share divided by earnings per share. So let’s take a look at it.

AT&T has a current dividend rate at $1.8 a share.

AT&T earnings at the end of 2012 was 1.25 a share

Adding these two numbers to the equation you get a dividend payout ratio of 144%

(payout ratio = 1.8 [DPS] / 1.25 [EPS] = 1.44 or 144%)

Did you notice what’s wrong with the ratio? The ratio is calculated from a number which already happened in the past. But I do not care what happened in the past! I want to know what is happening today or what will be happening in the near future.

Calculating ratio using numbers from 2012 has no longer any value, there is no sense in it. It was, it is gone, it is history, and I have no longer interest in it.

The proper way to check the ratio is to look forward. Look at the company’s outlook and their own expectations.

To do that, I want to pull the estimates for 2013 year. It is actually what is happening now anyway. Not what was three months ago. The expected EPS for 2013 is 2.52 and since the dividend ratio is still the same, let’s plug these numbers into an equation though:

(payout ratio = 1.8 [DPS] / 2.52 [EPS] = 0.71 or 71%)

A totally different picture, right?

You may say that AT&T may miss annual estimates, so let’s take a look at quarters and payout ratios:

As you can see, in the past quarters the company had enough earnings to cover the dividends and it even increased the dividends.

In 1Q 2013 we do not have data yet. The company will be releasing its earnings in April 23, 2013, however the estimate range is 0.60 to 0.67 and the analyst consensus is at 0.637.

How likely is the company going to miss?

Although it may happen, AT&T never missed analysts estimates (reviewed since 2009 until today) and it actually had 7 quarterly EPS surprises since 2009. So I do not expect the company to miss. But to be conservative, let’s stay at the low estimate of 0.6 EPS. With that, the company’s payout ratio in the 1Q 2013 was 75%.

Again, AT&T made enough money to cover the first quarter dividend.

What is the payout ratio outlook?

I can also look at estimates for 2014 and 2015 and if the dividend rate stays the same as today, the dividend payout ratio for 2014 will be 64% and for 2015 52%.

Based on the future outlook, it is clear that AT&T is confident paying it’s current dividend. It has enough earnings to pay the current dividend although the financial websites and advisers may tell you otherwise. The company may terribly miss the future estimates of course and when that starts happening then we should be concerned although the financial websites will be telling you “all is good” because their numbers are based on history.

When evaluating dividend payout ratio, always look in the future and never look back. Check what the estimate is, because the current dividend rate per share reflects the company’s present and mostly it nearest future and not the past.

Of course, there are other metrics I usually use when checking the company’s payout ratio such as cash flow and comparing the dividend payout ratio with cash flow, but that is a different story.

With this post I wanted to show that the number you may find on financial websites is basically worthless. It is the current rate versus the future of company’s earnings what matters. If you see the dividend rate suddenly increased and estimates stay as they are and the payout ratio starts screaming at you, you should start paying attention. The company is either doing very well (better than analysts estimates) or something else is going on under the hood. On the other hand if estimates start dropping and analysts start lowering their outlooks, again it is time to get worried.

How do you check the dividend payout ratio?