I have always been a follower of dividend payout ratio (the percentage of earnings paid out as dividends) as a yardstick of present and future performance in a dividend stock over dividend yield (annual dividends paid per share/price per share). Why? Fundamentally, my worst case scenario is that I am paid the same dividend no matter how the stock does and a company that manages its cash well long-term, by protecting or raising the dividend, will, over time, be rewarded by the market. As evidence, The Dividend Guy cited a study that found the higher the dividend payout ratio, the better earnings growth the company experienced.

I admit that my fundamental assumption that a stock may go sideways for years, as long as the dividend is protected, is a morbid way of looking at the stock market but dividend investing is cash flow investing. Dividend yields, since it relies in part on stock price- a variable related to future expectations set by third parties, is dependent partially on appreciation estimates by “expert” traders. Dividend payout ratios are a function of managing cash flows and, in my mind, more closely aligned with fundamental dividend investing. You can’t fake cash but you can massage earnings (as GE candidly admitted when it first disclosed that it was not going to meet expectations).

Certainly, the two ratios are intertwined. The nervousness over GE’s  current dividend focuses both on an extraordinary high dividend yield (over 10%) and dividend payout ratio (70%) and both payout ratios and yields generally rise and fall in lock-step. After all, if earnings are falling, payout ratios go up (assuming the dividend is not slashed) as well as yields as future performance is compromised by more cash being used to pay dividends rather than expanding the business.

In economic down-times, I tend to concentrate a lot more on dividend payout ratios with the expectation that a healthy payout ratio for its sector will mean that my cash flow will be protected short term and, as the economy picks up, well-managed companies will be growth leaders (I emphasis sector analysis in dividend analysis; a safe payout ratio for a tobacco company is different than a bank).

This logically leads to what exactly is a “safe” dividend payout ratio? The Dividend Guy has cited in the past 60% (assume normal market conditions). This seems to be backed up by Jeremy Siegel’s analysis on historical dividend payout ratios (scroll down to see the chart). My rule tends to be the more mature the industry, the higher a tolerable payout ratio can be. For example, Rothman’s, a tobacco company, before it went private had a dividend payout ratio of approximately 80% at times but, given that manufacturing and processing tobacco has not substantially changed for many years, it was a safe payout ratio.

I do not dismiss dividend yield as an indicator of dividend safety and I do not want to give you the impression that I downplay it at all. However, the question in my mind is not “is the dividend yield sustainable?” but “is the dividend payout ratio sustainable?” I always ask the payout ratio question before the yield question. Both questions need to be asked but I focus on the cash consideration first.