Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / Why the Dividend Payout Ratio Matters More Than Yield
Transcript
- Lucas: If I told you a stock yields seven percent, you'd probably think it's a great income play. But if I also told you that company pays out ninety percent of its earnings as dividends, you might think twice. Luna: Right, because the payout ratio tells you how sustainable that dividend actually is. A high yield with a high payout ratio can be a trap. Lucas: Exactly. And in this market — with the ten-year Treasury at four-point-four-seven percent and the Fed funds rate at three-point-six-three — investors are hungry for yield. But chasing yield without checking the payout ratio is how you end up owning a dividend cut. Luna: So let's define it. The payout ratio is the percentage of earnings a company pays out as dividends. If a company earns one dollar per share and pays fifty cents, its payout ratio is fifty percent. Lucas: Right. And the lower the ratio, the more room the company has to maintain or grow the dividend during tough times. A ratio above eighty percent is a yellow flag. Above ninety percent is a red flag. Luna: But some industries naturally have higher payout ratios — utilities, real estate investment trusts. So it's not one-size-fits-all. Lucas: True. But even within industries, comparing payout ratios can help you spot the outliers. Let's look at some names in the news this week. Procter & Gamble, Johnson & Johnson — both consumer staples — have been up four and a half and four percent respectively over the last five days. Luna: And both have payout ratios around fifty to sixty percent. That's very sustainable. Lucas: Correct. PG's yield is about two-point-three percent. Not exciting. But that dividend has been increased for over sixty consecutive years. Compare that to Verizon, which yields around six-point-five percent but has a payout ratio north of ninety percent. Luna: And Verizon's stock is down nearly five percent in the last five days. The market is pricing in risk. Lucas: Right. Verizon's dividend has been under pressure because its earnings are barely covering the payout. When interest rates are elevated — as they are now — companies with high debt and high payout ratios get squeezed. Luna: And that's exactly what we've seen. Verizon's five-year weekly chart shows a dividend that's been flat since 2020. No growth, and the payout ratio keeps creeping up. Lucas: So the lesson is: don't look at yield in isolation. A six percent yield from a company with a forty percent payout ratio is far safer than a six percent yield from a company with an eighty percent payout ratio. Luna: And the current rate environment reinforces that. With the ten-year Treasury at four-point-four-seven, investors can get a decent risk-free return. So why take on equity risk for a dividend that might get cut? Lucas: Exactly. That's the bar you have to clear. If a stock yields five percent but has a ninety percent payout ratio, you're not being compensated for the risk. You'd be better off in Treasuries. Luna: So what's a good payout ratio threshold for dividend growth investors? Lucas: I'd say under sixty percent is ideal for most companies. That gives the company room to reinvest in the business and raise the dividend annually. For high yield — say above four percent — try to keep it under seventy-five percent. Luna: And for companies that are more cyclical or have volatile earnings, you might want an even lower ratio. Lucas: Right. Energy companies, for example, can have wildly fluctuating earnings. A payout ratio that looks fine at oil at eighty dollars a barrel can become unsustainable at fifty dollars. Luna: So you're really looking for a cushion. A company that can maintain its dividend even if earnings drop by twenty percent. Lucas: Precisely. And that's where the payout ratio shines. It gives you a quick sense of the margin of safety. Luna: Now, what about companies with negative earnings? Their payout ratio is technically undefined, but they shouldn't be paying a dividend at all. Lucas: Right. If a company is losing money and still paying a dividend, it's borrowing or using cash reserves. That's not sustainable. Real estate investment trusts are a special case — they're required to pay out most of their income, so payout ratios are often high, but they're measured on funds from operations, not earnings. Luna: So for REITs, you look at the FFO payout ratio instead. Lucas: Exactly. And for other companies, you can also look at free cash flow payout ratio — how much of free cash flow goes to dividends. That's even more conservative. Luna: Let's take a quick step back. I know we've covered a lot of ground on payout ratios — and if you've found this useful, honestly, it's worth a coffee to us. If today's conversation helped you think about a dividend decision differently, you can support the show at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's the smallest ask. Keeps us ad-free and focused on the numbers. And we truly appreciate it. Luna: Alright, back to it. So when you're screening for dividend stocks, what's your process? Lucas: I start with yield — but only to set a floor. Then I look at the payout ratio. If it's above eighty percent, I dig deeper. Why is it so high? Is earnings growth expected to cover it? Is it temporary? Luna: And you can find payout ratio data on any financial site — Yahoo Finance, Morningstar, the company's investor relations page. Lucas: Right. And don't just look at one year. Look at a five-year trend. Is the payout ratio rising? That could mean earnings are declining or the dividend is growing faster than earnings. Either way, it's a warning. Luna: Let's apply this to a couple of names. Johnson & Johnson has a payout ratio around fifty-five percent. Its yield is about three percent. That's a solid combination. Lucas: And JNJ is up four percent this week. The market likes that stability. Compare to Altria — yield over eight percent, payout ratio over eighty percent. But Altria's stock is up five percent this week too. Luna: Right, but Altria's payout ratio is a concern. They've been paying out most of their earnings, and with declining cigarette volumes, that's a long-term risk. Lucas: Exactly. So even though the stock is up this week, the dividend might not be as safe as it looks. That's the payout ratio warning. Luna: So for investors building a dividend portfolio for the long term, focus on companies with low payout ratios, consistent earnings, and a history of dividend growth. Lucas: And in this environment — with the yield curve still positive but the spread narrowing — that kind of discipline matters more than ever. The ten-year minus two-year spread is down to thirty-eight basis points. That's not a recession signal yet, but it's worth watching. Luna: Right. If the yield curve inverts, high payout ratio stocks tend to get hit harder because investors worry about earnings. Lucas: So the takeaway: yield is a starting point, but the payout ratio is the reality check. Use it to avoid yield traps and build a portfolio that can weather whatever the market throws at it. Luna: And if you want to dig deeper, check the financial statements yourself. It's worth the time. Lucas: Alright, that's a wrap on payout ratios. Next time, we'll look at how dividend reinvestment plans can supercharge your returns over time. Luna: Looking forward to it.