A payout ratio is a dividend stock’s barometer that tells you if the company’s dividends could face a cut or not. A series of dividend cuts across the TSX from telcos to REITs has made the payout ratio as important as the price-to-equity (P/E) ratio.
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How to read a payout ratio in 60 seconds
Now, you don’t need to spend hours skimming through balance sheets to read this ratio. You can find what the ratio is trying to tell you in just 60 seconds if you know where to look.
The standard formula
Payout ratio = Dividend per share/Earnings per share
However, the denominator changes depending on how the company pays its dividends.
Reading a REITs payout ratio
REITs pay distributions from adjusted funds from operations (AFFO). The adjustment is for any repairs and renovations done to the property to make it leaseable. This repair cost is included in the rent and realized throughout the lease term. Slate Grocery REIT couldn’t sustain this adjustment and paused dividends as its payout ratio crossed 113% of adjusted funds from operations after adding leasing and improvement costs.
Reading an energy company’s payout ratio
Energy companies pay dividends from the distributable cash flow (DCF) from the existing projects. Thus, you will see that Enbridge’s payout ratio remains within its target of 60–75% of DCF even when it accelerates its capital expenditure or raises debt. The new projects pay their capex and interest before contributing to the DCF. When these projects earn back their capex, their contribution to DCF increases, and that’s when Enbridge accelerates dividend growth.
Meanwhile, Canadian Natural Resources and Suncor Energy (TSX: SU) are directly affected by oil prices, which makes their cash flow cyclical. Thus, they pay dividends from FFO, which is used for sustaining capital and dividends. In a way, the dividend is incorporated in their WTI breakeven price per barrel. Their payout ratio is around 30%, considering the cyclicality of their revenue and cash. They use upcycling to reduce debt and buyback shares to maintain their dividends even in a down cycle.
Reading a telecom company’s payout ratio
Telecom companies pay dividends from free cash flow (FCF), which is left after capital expenditure and interest payments. Their payout ratio took a hit when the first line of cash inflow (revenue) fell due to competitive pricing pressure. Their accelerated capital expenditure and increase in interest expense affected FCF and therefore dividends. Unlike pipelines that earn cash from long-term supply agreements with a predefined rate renewed periodically, telcos earn from subscriptions which are more volatile.
BCE and Telus both faced the same fate from the pricing change as they had invested heavily in fibre infrastructure. While FCF took a hit from rising interest rates, return on invested capital dropped in response to regulatory changes, pushing payout ratios above 100%. A payout ratio above 100% means the company is paying dividends from its pockets instead of operations.
Cogeco Communications has a 30% payout ratio. However, it has a capital-light model, as it leases BCE and Telus infrastructure instead of building its own. A 30% ratio is ideal, as its FCF is more volatile than that of BCE and Telus.
Investor takeaway
In order to read dividend payout ratios in 60 seconds, you have to first understand from where the company pays dividends, the average ratio and what counts as dangerous. An alarming payout ratio in a one-off year won’t cause a dividend cut unless the very source that funds the dividend has been affected, as in the case of telcos.
When the payout ratio is high, look at the funds flow from operations for any declines. Next, look at the debt levels to understand if high interest costs will eat up cash. Then look at the share buyback activity if it has decreased. No ratio should be seen in isolation. The above four metrics – payout ratio, funds from operations, debt, and share buybacks – will give signs if a dividend cut is coming or it is just a one-off adjustment.
