Dividend Payout Ratio vs. Cash Dividend Payout Ratio

by | Investment Analysis

In this post the Dividend Payout Ratio and the Cash Dividend Payout Ratio are compared to find out which is better at providing pertinent information to differentiate between various dividend paying companies.

Dividend Payout Ratios provide us valuable information on how much money a company is returning to shareholders and their ability to pay and increase the dividend. One of these ratios is far superior to the other.

Dividend Payout Ratio

Dividends

Investors seek dividends because they provide value today. Dividend are real, they can’t be faked or brought about by accounting fraud. Dividends provide an indication of the health of a company, especially in the long run.

Dividend paying companies make decisions based on priorities and needs of the company. They can return money to shareholders, reinvest for growth, pay off debt, or increase cash balances. We’re going to compare two ratios and how they succeed or fail in providing us the best information to make wise investment choices.

Since dividends are so vital to investment returns we don’t want to blindly buy dividend stocks. There are ratios that give us critical information when analyzing companies and their dividends.

Payout Ratio

This tells you how much of the company’s accounting profits are being given back to shareholders in the form of dividends. This is the most often used and quoted ratio.

Payout Ratio Calculation

Payout ratio = Total Dividends Paid / Net Income

or

Payout ratio = Dividends Per Share (Common and Preferred) / Earning Per Share (EPS)

A consistently high payout ratio may mean the company doesn’t have favorable places to invest its money for future growth of earnings and dividends. It may also mean the dividend is not as secure as a dividend of a company with a low payout ratio.

This metric should be analyzed in conjunction with the dividend yield. When considering just these two metrics, a high dividend yield and a low payout ratio would be the optimum. A low dividend yield and a high payout ratio would likely be a less attractive investment.

Cash Dividend Payout Ratio

The Cash Dividend Payout Ratio is harder to find (or calculate) and is most likely the reason it’s not used nearly as much as the Dividend Payout Ratio. The difference between the two ratios is larger than one might first guess given the small difference in the name. However, they are quite different; the main difference being that the Cash Dividend Payout Ratio concentrates on what is critical to paying the dividend: Cash Available!

Cash Dividend Payout Ratio Calculation

Cash Dividend Payout Ratio = Common Stock Dividends / (Cash Flow from Operations – Capital Expenditures – Preferred Dividend Paid)

The Cash Dividend Payout Ratio provides a much better analysis of the safety and ability of a company to carry on its business AND pay its dividend. Why?

First of all, starting with Cash Flow from Operations means that you have a number that can’t be manipulated as often net income is. This is the actual cash generated from the operations of the business. Where do dividends come from? Cash, not some number contrived from lots of accounting rules (net income).

Then we subtract the amount the company needed for investing in the future (capital expenditures). A forward looking company isn’t going to pay dividends until the capital required to meet future investing needs is secured. Therefore it makes since to subtract this from Cash Flow from Operations. Next, we subtract any preferred dividends because they usually have to be paid before a common stock dividend is paid.

What is left would be available for dividends if the company chooses. The dividend divided by this number results in the Cash Dividend Payout.

Which Dividend Payout Ratio is Better?

For review:

Cash Dividend Payout Ratio = Common Stock Dividends Paid / (Cash Flow from Operations – Capital Expenditures – Preferred Dividend Paid)

This is a MUCH better ratio than the more simple payout ratio most investors use. It’s most likely because of its simplicity that the Payout Ratio is more popular.

For those investors looking for a simple and easily found metric the Payout Ratio might be acceptable. However, there is no contest on which ratio provides a better analysis of whether a company has the ability to pay and possibly increase its dividend.

The Cash Dividend Payout Ratio uses cash flow instead of earnings that can be manipulated. It takes into account the capital needed to fund capital expenditures and preferred dividends, both of which would need to be paid before a dividend is paid.

The Cash Dividend Payout Ratio is far superior to the more popular Dividend Payout Ratio for analyzing the quality of a company’s dividend.

(YCharts.com publishes the Cash Dividend Payout Ratio for every stock in its database.)

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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