This post was originally made on August 3, 2006 on a former blog of mine.

I have been harping a lot lately on dividend paying stocks and have outlined many reasons why I lean towards them for long term accumulation. The following discussion is yet another “ah ha” thing I discovered while crunching some numbers once. In What to look for in Dividend Paying Stocks the first thing I mentioned was Payout Ratio. I want to delve a little further into why payout ratios are important and the power they have for your dividend income generating stability.

I can make a very useful case for building an income generating portfolio to retire on. For starters, with the uncertainty surrounding the length of one’s life it makes much more sense to me to insulate oneself from that by having a portfolio that generates income rather than one in which you have to draw down capital gains. I can hear the portfolio managers out there thinking “yeah but you can switch your capital gains to income production in the future.” Yadda, yadda, yadda. I am not here today to debate the merit of this strategy, only to make some further points about it.

In case you missed some of my previous examples, here is a little refresher. If you buy a $100 stock today and it yields 3% ($3 per year) you have yourself an asset. If that company has a long term history of dividend increases then you can expect them to steadily increase the payments over time. What that means is that your personal yield (the yield on your cost basis) will also increase. If they raise dividends by 8% for 10 years then your $3 would grow to $6.48 and your effective yield would then be 6.48%.

So why do payout ratios matter? Well, when I look for solid companies who may be increasing their yields over time I want to find companies that are insulated from slowdowns in the economy or in their own personal business growth. This insulation comes in the form of the payout ratio. For those of you unfamiliar with the term, the ratio is simply the dividend payment divided by the earnings per share. To demonstrate what I mean I have prepared a couple of spreadsheets.

I will use the all too familiar Altria (MO) numbers again because I am fond of their dividend history. This chart shows their Earnings Per Share, Dividend Payment, and Payout Ratio from 1996 to 2005. The compounded growth rates are the numbers on the bottom of each column. You’ll see that MO’s EPS only grew at 8% during this time while their Dividends grew at an 8.5% clip. They were able to do this because their payout ratios hover in the 40-60% range.

You’ll notice the high payout ratio was 76.4% in 1998 and the low was 42.3% in 2001. What this says is that IF a company is committed to raising its dividends each year then having the flexibility to do so even when earnings are slowing down is very important. If they had started out with a payout ratio of say 80% then they would have either had to lower their dividend payments or take on debt to pay the dividends. Neither is preferable for long term investors.

To give you a better idea about this payout ratio immunization thought I prepared another spreadsheet. What I have done here is hypothesize that MO’s EPS growth suddenly slows down to a staggering 5.3% per year (this is what the nominal GDP was from 1996 to 2005) and remains that slow forever. I then said, “hey, this company will want to continue increasing its dividends at 8.5% because the management likes pleasing the shareholders.” What you have then is two columns growing at different rates and the corresponding payout ratios to compare.

What you can see is that MO could continue raising dividends in this environment for 18 years without paying out 100% of their earnings. A more reasonable person might say they would never pay out more than 80%. Even so, that gets us 10 years of solid dividend growth even though the company had bad EPS growth.

This illustration was just to give you an idea about the importance of payout ratios on dividend payments and their possible future increases. Realize that the closer a company gets to 100%, the less flexibility it has when time to make payment decisions.

So if you can find companies committed to dividend increases, make sure they have the capacity to weather storms to do so.

Note: any company whose EPS growth rate slid to 5.3% may suffer some capital depreciation BUT what I am interested in is building an income stream with my capital today. I am less concerned about the long term capital gains than the increase in effective yield.

“Concentrate your energies, your thoughts and your capital. The wise man puts all his eggs in one basket and watches the basket.” -Andrew Carnegie

Note: Altria may be a personal or client holding. This is NOT a recommendation to buy it!

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