Episode 2: What is the Payout Ratio?

Before you invest in a dividend stock, how do you know if the dividend is safe? Could it be reduced or eliminated?

Checking to see if the dividend is safe has saved me thousands of dollars during my investing career.

In this episode you’ll learn if the dividend is safe. Is the dividend payout sustainable or is it at risk of being cut? This one important value can save you from making expensive investing mistakes. Also covered in this podcast:

– What is the payout ratio?
– What is EPS?
– How to calculate the payout ratio
– MetLife (MET) vs Allstate (ALL), which company has the lower payout ratio?

Watch today’s episode, and save yourself from making this dividend investing mistake.

Speaker 1 (00:00):
In this video, I’m going to show you how to save yourself from making expensive investing mistakes. We’re going to talk about the payout ratio. As dividend investors, we want to get paid for owning shares and we get paid in the form of dividends. So we want to make sure that the dividend is going to be safe, that the company’s not going to reduce the dividend or eliminate it. Hi, my name is Kanwal Sarai and welcome to the Simply Investing Dividend Podcast episode number two. Follow along as we cover the story of Jack and Jill as they navigate the world of dividend investing. In this episode, Jack is interested in possibly investing in Allstate, and Jill is looking at buying some stocks or shares in MetLife. Now, as you know, a stock or a share represents ownership in a company. MetLife has a little over 79 million shares outstanding.

(01:02):
If Jill was to buy all of the shares, she would own the entire company. Now, if she buys just five, 10, or 15 shares in the company, she’s still considered part owner of the company. And as part owner of the company, she’s entitled to the profits that the company is making. And those are given to her as dividends. Now, dividends are amazing. We’re dividend investors. You are literally getting paid. Cash gets deposited into your trading account for owning shares. Regardless of the stock price can go up and down after you’ve bought the shares, but as long as you own those shares, the company’s going to continue to pay you the dividends in cash into your trading account. So in this example, if a company is paying a dividend of $1 per share and Jill decides to buy a thousand shares, she’ll receive $1,000 every year for as long as she own those shares and as long as the company continues to pay the dividend.

(02:03):
She can spend those dividends if she wants, spend the money, or reinvest them into other dividend stocks. So Jack and Jill want to know, is the dividend going to be safe? Is the company going to continue to pay the dividend? Are they going to reduce the dividend or eliminate it? That’s the big question. So before we get into that, we need to cover one more thing. EPS. What is EPS? EPS stands for earnings per share. So this is basically the profits, how much money the company is making per share. So let’s take a look at MetLife because that’s what Jill is interested in investing her money in. So you can go to any website, Yahoo Finance, Google Finance, MSN Money, any stock website that’s going to give you stock price information. So in this example, Jill’s going to go to Yahoo Finance. She’s going to type in MetLife or MET, which is the stock symbol for this company.

(03:05):
And you’re going to see the stock price at the top right left-hand corner. There’s a whole bunch of numbers on the screen. The one we’re interested in and we’re going to focus on is EPS, earnings per share. So in this case, she can see today that MetLife has $3.95 earnings per share. Now remember, the company has a little over 79 million shares outstanding. You multiply that by $3.95, and you can see that the company has earned $315 million. So now, what does earnings have to do with dividends? We’re still looking at answering this question. So this is going to help us. What is the payout ratio? So the payout ratio is going to help us figure out, should I buy this company or should I skip it? So the payout ratio is really simple. It’s your annual dividend divided by the earnings per share. So let’s take a look at two real life examples.

(04:13):
Jill is interested in MetLife. Jack is interested in Allstate. These are both insurance companies. They’re both located in the US and they both pay dividends. Which one is going to be better over the other? So let’s start with Jill’s example with MetLife. We’re going to go back to Yahoo Finance. We already know the earnings per share is $3.95. Now we can see also on Yahoo Finance that the forward annual dividend is $2 a share. So what does that look like when we put it into our formula, the payout ratio? So we take the dividend divided by the earnings per share. The dividend is $2, the earnings per share is 395. So $2 divided by $3.95. Again, we want to express this as a percentage, is 51%. So what is that telling you? What is this telling Jill? It’s telling her that MetLife for every amount of money that they make, the earnings, so in this case 395, 51% of what the company earned is paid to the shareholders as a dividend.

(05:31):
So the company made $3.95 per share, and they paid a dividend of $2 per share to the shareholders. So what did they do with the rest of the money? They reinvested back into the company to grow the business. So this is a very healthy payout ratio. In fact, we look for companies with payout ratios of 75% or less. So this is good. This means MetLife has room to increase the dividend in the future, right? It’s $2 a share. They can go up to 210, 215, 220, 230. There’s room here to increase the dividend because they have the earnings to support that. Okay. So this is good. This is a good example. Now let’s take a look at Jack who’s interested in Allstate. So he wants to know, is Allstate a good investment? What’s the payout ratio here? So we’re going to do the same thing.

(06:26):
We go to Yahoo Finance. We can see that the earnings per share is $3.8 cents. We can see that the dividend for Allstate is $3.40. So now let’s put that into our formula. Again, payout ratio is the dividend divided by the earnings per share. So the company earned a dividend of $3.40 divided by $3.08, which is the earnings. And we can see that we end up with 110%. Okay. Does that make any sense? The company earned $3.08, but it paid the shareholders $3.40. Right? That doesn’t make any sense. Where did they come up with the money to pay the shareholders? There’s not enough earnings there to pay the shareholders. So in this case, the companies, typically what they do is they’re borrowing money from someplace else to pay the shareholders to pay the dividend. Now, a couple of things could happen here. So number one, we can see here that the company doesn’t have room to increase the dividend.

(07:33):
So they may or may not increase the dividend next year, but it doesn’t look so good right now. Number two, they’re going to have to increase their earnings if they want to keep paying the dividend. And if they want to keep increasing the dividend, they’re going to have to increase their earnings. And the earnings are right now at $3.08 a share. That has to come up. Option number three, which we don’t like as dividend investors, option number three is the company may have to reduce its dividend, right? Because this payout ratio of 110% is not sustainable. Absolutely not. And you’ll see companies online with payout ratios of like 200%, 300%. That’s a red flag. If you see things like this, you need to move on. And remember, for us, we’re looking at companies with 75% or less. Okay? So in this case, when we compare the two insurance companies, MetLife and Allstate, now as of this recording, these are the numbers today.

(08:36):
This will obviously change whenever you watch this video or listen to the podcast. But as of this recording, all things considered equal, MetLife is going to be a better investment. We can feel confident that the dividend is secure. We can feel confident that the company has room to increase its dividend. We can’t say the same for Allstate. Okay? So that’s very important to look at. And this is just the one simple sort of criteria that we look at that’s going to save you for making expensive investing mistakes. I’ve been doing this for over 22 years. I’ve made my share of mistakes, so I’ve avoided looking at the payout ratio and bought a stock because the dividend was really high and the dividend yield was really high and I’ve paid for that mistake many times over. So hopefully this will save you from making the same mistake that I made.

(09:36):
So payout ratio, very important. So I showed you how to get the information. We need the earnings and we need the dividend, right? Because that’s how we get the payout ratio. We need those two numbers. So you can go to Yahoo Finance or any website and get those two numbers when you evaluate companies, whether you should buy them or not. Now, the Simply Investing platform, which I built, took two years to build, the Simply Investing Platform calculates the payout ratio automatically for you every single day for every stock in the US and in Canada. And then we show it to you on the screen and you can see it right there. If the payout ratio is over 75%, we highlight those numbers. So right away you can say, okay, this company fails rule number seven, I’m going to skip it, move on to something else.

(10:30):
So the platform is going to save you a lot of time. All that information is there. Now, does this mean you should go out and buy any dividend stock with a very low payout ratio? And the answer is no. And neither should Jack and Jill, right? Even though we’ve given this example of MetLife and Allstate, it doesn’t mean they should just jump in and put all their money in MetLife because the payout ratio was really low.

(10:56):
We invest in quality dividend stocks when they’re priced low, undervalued. Okay? We looked at undervalue in episode one. So if you’re interested in that, go back and listen to episode one. We teach you exactly how to figure out when a stock is priced low, but we also want to invest in quality stocks, not just any stock, not just any stock with a low payout ratio. It has to be a quality stock. So how do you know when it’s a quality stock when you’re looking at a company? To help you with that, I created what I call the 12 rules of simply investing. You can see the rules on the screen. For those of you on the audio podcast, I’ll just quickly go through them. Rule number one, do you understand how a company is making money? Rule number two, 20 years from now, will people still be using its products or services?

(11:46):
Rule number three, does the company have a low cost competitive advantage? Rule number four, is it recession proof? Rule number five, is it profitable? Rule number six, does it grow its dividend? Rule number seven, can it afford to pay the dividend? That’s what we just looked at, the payout ratio. Rule number seven, very important. Rule number eight is the debt less than 70%. Rule number nine, avoid companies with recent dividend cuts. Rule number 10, does the company buy back its own shares? Rule number 11 is a stock priced low, so we covered that in episode one. Rule number 12, keep your emotions out of investing. Before you invest in any stock, make sure it passes all of the 12 rules. Not eight of the 12 or six out of the 12 has to pass all of the 12 rules. If it doesn’t, move on to something else.

(12:41):
I’ve been using these rules for over 22 years. These are designed to save you, prevent you from getting yourself into trouble, buying a stock and then realizing, oh, they cut the dividend, or buying a stock and realizing, oh, it was priced too high and now the stock is tanking. Okay. The rules are designed to save your hard earned money, keep your capital safe, and to grow your investments, to grow your dividends safely and reliably and predictably, regardless of what happens with stock prices. Stock prices go up and down all the time. Okay. So if you’re interested in learning more about the 12 rules, I cover those in the Simply Investing course with real life examples. The Simply Investing Platform I just showed you briefly, it applies these rules to all the stocks in the US and Canada every single day, and it tells you which company failed which rule or which company passed all of the rules.

(13:40):
Okay. So if you like this episode, make sure you click on the like button, hit the subscribe button as well. I have new episodes coming out every week, so be sure to tune in next week. Check out my website, simplyinvesting.com. Future episodes I’ve got coming down the pipe, we’re going to cover the power of dividends, how to beat inflation using dividends, guest interviews, and more. Thanks for watching, and I’ll see you next week.