Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / Why Dividend Investors Should Watch Payout Ratios in a Rising Rate World
Transcript
- Lucas: So we talk a lot about yield on this show — how much cash a dividend stock throws off relative to its price. But there's another number that I think gets less attention than it should, and right now it's flashing some pretty interesting signals. Luna: What number are we talking about? Lucas: The payout ratio. Specifically, the percentage of a company's earnings — or better yet, its free cash flow — that it pays out as dividends. And in this environment, where the 10-year Treasury is yielding around 4.53 percent and the Fed funds rate is sitting near 3.63 percent, a lot of investors are reaching for yield. But a high yield can be a trap if the payout ratio is unsustainable. Luna: Right. Because a company can only pay out what it earns over the long run, unless it's borrowing to fund dividends. Lucas: Exactly. And borrowing to pay dividends is a red flag. So let's look at a couple of real examples. Take a consumer staple like Coca-Cola — ticker K-O. It's yielding around 2.8 percent, which isn't huge, but its payout ratio based on earnings is about 70 percent. And its free cash flow covers the dividend comfortably. That's sustainable. Luna: Now compare that to a high-yield REIT, like Realty Income — ticker O. It yields around 5.2 percent, but its payout ratio based on adjusted funds from operations is about 80 percent. That's still manageable, but if interest rates stay elevated, their cost of capital goes up, and that payout ratio could creep higher. Lucas: And that's exactly the kind of nuance you miss if you just look at yield. The S&P 500 is at 7,267, the Dow is near 50,000 — we're in a bull market that's been driven by a handful of tech names. But dividend stocks in the Dow, like J&J or Procter & Gamble, have much lower payout ratios — around 50 to 60 percent. They've got room to grow dividends even if earnings dip. Luna: So what's a good rule of thumb for payout ratios? Lucas: For most companies, a payout ratio under 60 percent is generally safe — it means they're retaining enough earnings to reinvest. Between 60 and 80 percent, you want to check free cash flow. Above 80 percent, and especially above 100 percent, you're in danger zone territory. And right now, some of the highest-yielding stocks in the market have payout ratios north of 90 percent. Luna: And that's where the ETF data gets interesting. VYM, the Vanguard High Dividend Yield ETF, is trading around 157. Its top holdings include companies like J&J and Procter & Gamble, which have payout ratios in that 50 to 60 percent range. SCHD, the Schwab U.S. Dividend Equity ETF, at about 32 dollars, also focuses on dividend growth and screens for payout ratio sustainability. Lucas: Right. And DVY, the iShares Select Dividend ETF, at 156, has a slightly higher yield but also tends to include more utilities and REITs, which can have higher payout ratios. So if you're looking at these ETFs, it's worth understanding the underlying payout ratios of the holdings, not just the yield. Luna: Let's talk about a specific example of a payout trap. Verizon — ticker V-Z — yields around 6.5 percent. That sounds amazing. But its payout ratio based on earnings has been above 80 percent for a while. And their free cash flow has been under pressure because of heavy capital spending on 5G. Lucas: Exactly. Verizon's dividend looks juicy, but the safety margin is thin. Compare that to a company like Microsoft, which yields less than 1 percent but has a payout ratio under 30 percent. That's not an income stock, but it shows you how payout ratio signals growth potential versus income sustainability. Luna: So for someone building a dividend portfolio in June 2026, how should they use payout ratios? Lucas: I'd start by screening for payout ratios under 70 percent based on free cash flow, not just earnings. Earnings can be manipulated, but cash flow is harder to fake. Then look for a history of dividend growth — companies that have raised dividends for 10, 20, 25 years straight. Those are the dividend aristocrats. They tend to have strong payout ratio discipline. Luna: And with the yield curve still inverted — the 10-year minus 2-year spread is about 42 basis points — that's a sign that the market expects rates to come down eventually. That would be good for REITs and utilities, which have been under pressure. Lucas: Right. But even if rates come down, a company with a high payout ratio and weak free cash flow won't suddenly become safe. The payout ratio is a fundamental measure of financial health. It tells you whether the dividend is built to last or built to break. Luna: And that's the kind of insight that can save you from a nasty surprise. Which reminds me — we keep this show ad-free because we think that makes for a better listening experience. If you find value in these conversations and want to support that choice, you can do so at buy me a coffee dot com slash fexingo. No pressure, just an option. Lucas: Yeah, we appreciate those who do. It helps us keep the focus on what matters — helping you make smarter decisions with your money. Luna: Exactly. So back to payout ratios — one last quick example. Altria, ticker M-O, yields around 8 percent. Their payout ratio based on earnings is over 100 percent. That's a red flag. They've been able to sustain it by cutting costs and using debt, but it's not a long-term strategy. Lucas: And that's the kind of stock that looks great in a yield screen but could cut its dividend when the next downturn hits. So the takeaway: don't chase yield without checking the payout ratio. Look for companies with payout ratios under 70 percent, growing free cash flow, and a history of dividend increases. That's the recipe for long-term income. Luna: And if you want to dig into the numbers, the ETFs we mentioned — VYM, SCHD, DVY — are good starting points, but always look under the hood. Lucas: Absolutely. That's it for today. Next time we'll look at how dividend investors can use covered calls to generate extra income without taking on too much risk.