Payout pitfalls: The secret number behind your dividends

Fri May 3, 2013 11:03am EDT

By Chris Taylor

NEW YORK May 3 (Reuters) - If there is a stock market superhero these days, it is the humble dividend.

The companies in the Standard & Poor's 500 Index doled out a record $281.5 billion in dividends in 2012, and payouts in 2013 are slated to rise even higher.

Investors adore them: Dividend-paying companies best nonpayers by 8 percent a year in total returns, according to Ned Davis Research Group. Furthermore, the S&P 500 is yielding 2.02 percent, more than the 10-year U.S. Treasuries' 1.66 percent.

But before you snap up the fattest dividend you can find, take a look behind the curtain. Do not just consider yield, but also the payout ratio, which is the percentage of earnings that a company is forking out in dividends.

The companies in the S&P 500 are currently paying out 36 percent of their earnings in dividends. That is well below the long-term average of 58 percent, according to Ned Davis.

But some companies go much higher, borrowing money or dipping into savings to protect their dividends even when they exceed earnings. Once a company starts paying out more than 80 percent of earnings in dividends, analysts become concerned.

Currently, 49 companies in the S&P 500 are above that 80 percent mark, according to Chicago research firm Morningstar.

"A payout ratio above 100 percent is more than a red flag," says Sam Stovall, chief equity strategist for S&P Capital IQ. "It is a red flag combined with a blinking strobe light combined with an airhorn, to indicate that there is something wrong here."

After all, a company paying out more in dividends than it earns raises serious questions about how sustainable that payout really is.

Rural telephone operator Windstream Corp, for instance, is wrestling with a dividend equivalent to 357 percent of its earnings, according to Morningstar. A company spokesman says free cash flow is a better metric than earnings, to gauge a company's ability to pay.

AT&T Inc is paying out a generous 141 percent of its earnings to shareholders. A spokeswoman says the company's balance sheet remains among the strongest in the industry.

If a payout ratio rises too high, however, it might indicate a potential dividend cut is in the offing, to free up more cash.

Experts stress there are no foolproof ways to predict a dividend cut, since every company possesses a unique financial outlook and earnings projections. But just look at two prominent companies that recently opted to trim future payouts: utility Exelon Corp, which has a trailing 12-month payout ratio of 148 percent, and rural telecommunications service provider CenturyLink Inc, whose ratio is even higher at 232 percent.

A modest payout ratio, on the other hand, indicates that a company should have no trouble paying the dividend and probably has room to increase it. Some blue-chip companies that marry an attractive yield with a reasonable payout ratio, according to S&P's Stovall: Chevron Corp, General Electric Co and McDonald's Corp.

"Over the past 10 years, companies with payout ratios lower than 50 percent have performed better than those with higher ratios," says analyst Michael Amenta of Norwalk, Connecticut-based financial research firm FactSet Research Systems. "That is a nice guideline to follow."

Companies that paid out less than 50 percent of earnings racked up 0.68 percent monthly gains over the past decade, while those that paid out between 75 percent and 100 percent trailed with a 0.53 percent monthly increase. Those whose payout ratios rocketed above 100 percent lagged even more, with just 0.51 percent monthly gains over the 10-year period, Amenta said.

So how should payout ratios affect your own investment choices? Some guidelines for doing the math:

- Look at multiyear trends. A company might pay out more than 100 percent of earnings on a temporary basis because it had a big one-time charge or due to depressed earnings during a recession.

"A multiyear trend is a more useful way to get some context," says Amenta. "For instance, telecom companies recently had some one-time charges related to Hurricane Sandy that sent their payout ratios higher than usual. But I wouldn't look at that as a long-term indicator of their inability to pay."

- Consider the sector. A relatively high payout ratio may not be horrible if it is the industry norm, but the outliers should be cause for concern. "Utilities and telecoms have higher payouts, and information technology has traditionally had the lowest," Amenta says. "Payout ratios tend to be consistent across certain industries."

As of the end of 2012, for instance, utilities had an average payout ratio of 141 percent, according to Howard Silverblatt, S&P's senior index analyst. That compares with more restrained sectoral averages like consumer staples, at 47 percent, and IT, at 26 percent.

- Don't be seduced by an above-average yield. "If you reach for a dividend that is 5 or 6 percent ... you could find out that yield is going to be cut," says Stovall. "That is why if you get a payout ratio over 100 percent, some people start waving that red flag very aggressively."