Question

Explain whether an investment fund should invest in companies with high dividend payout ratios or low dividend payout ratios (400 word response minimum)

Answer 1

The DPR expresses what percentage of earnings the company paid out to its owners or shareholders.

Dividend Payout Ratio = Dividend per share (DPS) / Earnings per share (EPS)

1. Loss Making: A payout ratio less than 0% is only possible if the analyst’s estimates for EPS for the next year end are negative. The eqyuity shareholders are paid dividend only out of the residual profits. If the bottom line itself is expected to be negative next year, then the dividend is not likely to continue going forward. But some companies, still distribute dividends despite this situation due to 2 reasons:

a. Due to the fear of being judged in a deficient state, which can lead to fall in share prices.

b. It’s a matter of pride for a lot of companies to continue paying dividends. Some companies have a long history of paying dividends—as far back as 50 years and in some cases even 100 years. Cutting or eliminating a dividend that was being paid for such a lengthy period of time can have a devastating impact on shareholder confidence.

2. Good : A range of 0% to 35% is considered a good payout. A payout in that range is usually observed when a company just initiates a dividend. If the company has just started paying dividends, then such companies might not be valued as much as those companies which have been paying dividend from long back. Usually, low P/E stocks are found in this category.

3. Healthy : A range of 35% to 55% is considered healthy and appropriate from a dividend investor’s point of view. A company that is likely to distribute roughly half of its earnings as dividends means that the company is well established and a leader in its industry. It’s also reinvesting half of its earnings for growth. It also means that the company is well established and a leader in its industry.

4. High : Payout ratios that are between 55% to 75% are considered high because the company is expected to distribute more than half of its earnings as dividends, which implies less retained earnings. A higher payout ratio viewed in isolation from the dividend investor’s perspective is very good. But, it also implies low retained earnings for growth. This is not a good sign.

5. Very High : A payout ratio that is between 75% to 95% is considered very high. It implies that the company is bordering towards declaring almost all the money it makes as dividends. This increases the risk of the company cutting its dividends because our formula is forward looking. To maintain a healthy retention ratio, the company would either not grow its dividend or cut it down.

6. Unsustainable : Companies that have forward-looking payouts of 95% to 150% are distributing more money than they earn. A poor earnings estimate is likely to result in an unsustainable payout ratio in the triple digits. Only two things can happen from here: the dividend would be cut or eliminated altogether.

7. Very Unsustainable : If the payout ratio exceeds 150%, it’s as bad as a company that has negative payout ratios.To emphasize the difference between the two, negative payout ratios result when the earnings estimates are negative and the company is still paying a dividend today as explained above, while payout ratios in the triple digits occur when the company has positive earnings, but they are still less than the distribution the company is making.

8. The Bottom Line : Investors should always prefer healthy payout ratios over high payout ratios. Very high dividend distributions may be attractive in the short term, but they may not last going forward as discussed above. New Dividend Initiators can also be preferred if someone is looking for a hybrid value/income pick.

Thus, to sum-up, an investment fund should invest in companies with healthy dividend pay-out ratios which is about 35%-55% of its profits.