Why the dividend payout ratio is the one number that grows an income investors real wealth faster than any other financial ratio I know

by , 21 September 2017
Why the dividend payout ratio is the one number that grows an income investors real wealth faster than any other financial ratio I know
Investing for income is a wonderful thing.

Income is what gives you the freedom to enjoy your life.

Income supercharges your retirement savings.

More importantly, income is what you need to ensure you and your family live a comfortable life.

So what's really the best form of income?

Dividends.

Dividends are “rewards” you get for investing in stocks. And they're vital to overall performance of your portfolio.

But how can you make sure that your investment is likely to keep paying out its dividend?

Read on to find out…

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Not all dividend paying shares are worthy investments
 
The most basic, yet important thing to know is, companies must be able to afford paying its shareholder dividends.
 
Usually, a company taps into its profits to pay dividends. This means, they essentially have less money to use to grow the business.
 
Unfortunately, you’ll get companies that pay-out most of their profits in dividends. Eventually, they won’t be able to sustain this.
 
Consequently, the company will end up cutting or scrapping its dividend policy, which will result in a lot of unhappy shareholders.
 
Forced selling will ensue and shareholders will lose a fortune.
 
So how can you check if your investments can sustain their dividend pay-outs?
 
This one number will tell you if your shares will continue to pay dividends every year
 
It's called the "dividend-pay-out ratio."
 
By definition, it’s the percentage of earnings the company pays out as dividends, usually on an annual basis.
 
But as an investor, what you’re looking for in a dividend-pay-out ratio is sustainability.
 
For example, a dividend-pay-out ratio of more than 100% is usually not sustainable.
 
At that pace, the company will eventually run out of money.
 
Likewise, a low dividend-pay-out ratio suggests the company isn't returning much money to shareholders.
 
A sustainable pay-out ratio should be higher than 30% but no more than 60%. This suggest the company pays a generous dividend and still has breathing room in the case of short-term market fluctuations.
  
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Where you can you find the dividend pay-out ratio
 
You can find this one number when a company releases its financial statements.
 
Or to work it out is very simple: If a company reports earnings of 50c and dividends of 25c, its dividend pay-out ratio is 50% ((25c/50c)*100).
 
The bigger the gap between a company’s dividend and its earnings, the better the chance the company has of maintaining it if earnings come under pressure.
 
As earnings can sometimes be manipulated through the issuing of new shares, another way to work out dividend pay-out ratio is to use free cash flow per share. The more cash a company generates, the likeliness it will pay-out dividends.
 
You’ll also find this in a company’s financial statements.
 
Always remember, knowledge brings you wealth,
Joshua Benton, South African Investor
 
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