Dividend Payout Ratio: Is a Dividend Safe?

A high dividend yield is only attractive if the company can keep paying it. The payout ratio is the quickest way to check whether a dividend is comfortably covered by profits or stretched to breaking point.

The formula

Payout ratio = dividends per share ÷ earnings per share

If a company earns $4.00 per share and pays $1.60 in dividends, its payout ratio is 40%. It keeps the other 60% to reinvest, pay down debt or buy back shares.

The cash flow version

Earnings can be distorted by non-cash charges, so many investors also check the free cash flow payout ratio: total dividends paid ÷ free cash flow. Dividends are paid in cash, so this version often gives a more honest picture. If both ratios are comfortably below 100%, the dividend is well covered.

What's a healthy payout ratio?

• Below about 60%: generally comfortable for most companies, with room to keep raising the dividend.
• 60% to 80%: common for mature, stable businesses such as consumer staples and utilities. Fine if earnings are steady.
• Above 100%: the company is paying out more than it earns. That can't last long unless earnings recover, and it often comes before a dividend cut.

Some businesses are measured differently. REITs must pay out most of their taxable income, so their payout ratios are usually judged against funds from operations (FFO) rather than earnings. Partnerships use distributable cash flow.

Warning signs of a dividend cut

• Payout ratio rising toward or above 100% for several quarters.
• Falling earnings or free cash flow.
• Rising debt being used to fund the dividend. Check the debt-to-equity ratio.
• A dividend yield far above peers, which often means the share price has fallen because investors expect a cut.
• Management comments about "reviewing capital allocation."

Low payout isn't always better

A very low payout ratio leaves room for dividend growth, but a fast-growing company may be better off reinvesting most of its profits. What matters is whether the payout fits the company's growth and stability.

Put it to work

Find dividend payers in the stock screener, then check each one's earnings and cash flow history on its stock page. Learn the dividend calendar in how dividends are paid, and project your future income with the dividend calculator. New to income investing? Start with dividend investing for beginners.

This article is educational and not investment advice.