Why dividend stocks with low payout ratios may be better than those with high yields

Dividend-paying stocks S&P500 have historically outperformed their non-dividend paying index peers. Dividend-growth the companies in the index performed even better.

So should we buy the top dividend yielding stocks in the S&P 500 and call it a day?

Maybe, but there’s a final (and less popular) metric that has historically led to outperformance: payout ratio. Specifically, dividend-growing stocks that maintain a payout ratio below 50% help create the exact type of stocked pond that people like to fish in, providing investors with a healthy balance between returning cash to shareholders and financing business growth.

Therefore, it is not the top quintile of the highest yielding stocks (and their average payout ratio of 74%) that outperform at the highest rate, but the second quintile (and its average payout ratio of 41%), according to data from Wellington Management.

Let’s find out what this means for investors looking to optimize their dividend strategy.

Image source: Getty Images.

High dividend yield, low growth prospects

Although high-yield dividend stocks may be attractive at first glance, many tend to have higher payout ratios. The payout ratio is a stock’s dividend payout as a percentage of its net income, and it can quickly tell investors how much of a company’s profits go directly to shareholders.

When these high-yielding stocks continue to increase their dividend payouts over time, they eventually begin to test the limits of their financial security, paying out more of their income.

High payout ratios generally mean two things.

First, the business will have less money to reinvest in the business, expenses that could have fueled future sales growth, possibly increasing the bottom line. Sales growth is a strong indicator of a stock’s long-term performance, putting companies with high payout ratios at a disadvantage due to their hampered growth prospects.

Additionally, if a company has a high payout ratio, its potential for dividend growth is also limited – or even worse, it may need to cut its distributions to maintain financial security. While dividend cuts are far from a death knell (sometimes even sound decisions), they usually lead to a sell-off in stocks as income-focused investors flee.

S&P 500 companies that cut their dividend not only underperformed their peers over a 48-year period, but produced a negative overall annual return, reinforcing the importance of a well-funded dividend.

Low payout ratios, long-term growth potential

On the other hand, stocks with low payout ratios offer a balanced approach between returning cash to shareholders and funding future growth. With this extra cash available to reinvest in the business, a flywheel effect can set in.

First, a portion of excess profits is funneled back into the business, creating new sales that trickle down to the bottom line. With this rising net income, the company can increase its dividend, often without increasing its payout ratio, as earnings and dividends paid grow at a similar rate.

Additionally, if the company still has profits to spare, management may also consider reducing the number of shares through stock buyback programs. For example, consider the decline in the number of shares for two stocks with a low payout ratio, Lowe’s and Union Pacific.

Outstanding Stock Chart LOW

Data by YCharts.

Despite the capital required to maintain their respective operations, these two companies not only funded many years of annual dividend increases, but also rapidly reduced the total number of shares outstanding over the past decade. Fewer shares make dividends cheaper to maintain while increasing earnings per share, which reinforces the flywheel effect.

Because of these advantages, seeking low payout ratios rather than high returns is like choosing long-term cash flow potential over higher short-term income.

The best of both worlds

Better yet for investors, a handful of stocks offer relatively high dividend yields and low distribution rates. Let’s see three of them here:

Metric Cummins Intel Target
Dividend yield 2.9% 3.0% 1.7%
The payout ratio 38.3% 28.6% 22.4%
Maximum dividend potential 7.6% 10.5% 7.6%
Consecutive years of dividend increases 8 19 53

Source: Yahoo! Finance. Maximum dividend potential = dividend yield/payout ratio.

Note that despite not having the highest dividend yield, Intel has the highest maximum dividend potential based on its dividend yield divided by its payout ratio. Likewise, Target has a dividend yield about one percentage point lower than Cumminsbut they have comparable maximums.

I bring these three companies to illuminate the power of a low payout ratio. Yes, you may be sacrificing short-term dividend income by foregoing high-yielding stocks, but your long-term dividend potential should one day eclipse that high initial income if you hold onto it for the long term.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

About Warren Dockery

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