To be an income investor, it is critical to analyze not just a stock’s dividend yield but also the level of risk associated with a dividend payout. One mustn’t focus only on the stocks that carry the highest payout ratios as that can get investors in trouble; this is because the stocks with the highest yields are often in distressed financial condition. Abnormally high yields look attractive on the surface, but if a company cuts its dividend, investors are left with a much lower yield and usually significant capital losses as well.
As a result, income investors need to make sure to the best of their abilities that the stocks they are investing in have sustainable dividends. One of the most basic tools to evaluate the sustainability of a stock’s dividend is the payout ratio. Investors are likely familiar with the basic payout ratio. But in the current market environment, certain stocks are showing negative payout ratios. That can be a very confusing scenario for which investors may not be prepared. Below, Dividend.com discusses the prevalence of negative payout ratios and the implications for investors.
Introduction
The first concept to discuss is the payout ratio in its simplest form. The equation to calculate the traditional payout ratio is to divide a company’s annual dividend per share by the company’s earnings per share. For example, if a stock pays a $1 dividend each year and earns $3 per year in profits, the payout ratio is 33%. In this example, the company distributes only one-third of its earnings per share as a dividend. This implies that the company has sufficient flexibility to increase its dividend in the future, as long as its earnings per share do not fall dramatically.
Taking the discussion one step further, it is even more useful to calculate the payout ratio using forward-looking earnings projections. After all, calculating a payout ratio based on trailing earnings only tells the investor what a company’s payout ratio was last year; it does not signal the future dividend sustainability of a company. To be forward-looking, the investor must either calculate next year’s earnings on his or her own, or use existing analyst forecasts. The formula for forward-looking payout ratios would be the current dividend, or a projection of future dividends, divided by the next year’s earnings per share estimates.
But be careful: when using forward estimates, one must account for the possibility that a company will lose money in future periods. That would create a negative payout ratio.
Interpretation of Negative Payout Ratios
If a company is projected to lose money in a forecasted period, mathematically that would make the payout ratio negative. For example, if a company pays a $1 annual dividend but is expected to lose $4 per share next year, its forward-looking payout ratio will be -25%. This can be very confusing since obviously no company can pay dividends if it loses money. Sometimes, companies will maintain their dividends even if they lose money in a year. In that instance, the company raises the necessary funds through a combination of cash on hand, issuing debt or equity, or selling assets to make the dividend payment.
The one industry most vulnerable to negative forward payout ratios right now is the oil and gas industry. Due to the huge collapse in commodity prices, many companies in the energy and materials sector are projected to lose money over the next 12 months. As the price of oil in the United States has fallen from $100 per barrel two years ago to its current level of $30, energy companies are suffering massive losses. Here is a list of a few companies with negative forward payout ratios.
| Company Name | 2016 Expected EPS | Annual Dividend | Payout Ratio |
|---|---|---|---|
| Apache Corp. (APA ) | -$1.61 | $1 | -62% |
| EOG Resources (EOG ) | -$0.95 | $0.67 | -70% |
| Anadarko Petroleum Liquid error: internal | -$2.95 | $0.20 | -6.80% |
*Financial numbers as of February 12, 2016.
There are other sectors that have experienced negative payout ratios in the recent past as well. One prominent case was the financial sector in the recession of 2008. During the financial crisis, banks like Bank of America (BAC ) and Citigroup (C ) suffered steep losses. That caused their payout ratios to go negative, which eventually led to these two, and many other big bank stocks, cutting their dividends.
The Bottom Line
Many companies strive to reward shareholders with quarterly dividend payments, but those dividends must be supported by underlying profits. If and when a company incurs losses, its payout ratio will go negative, which is a major red flag that the dividend is in danger of being cut. An ideal payout ratio is between 35% to 55%, a comfortable range which allows companies to continue raising dividends each year.
To learn the basics about the dividend payout ratio, read our article The Truth About the Dividend Payout Ratio. Make sure to also take a look at our articles on target payout ratios and on the ideal payout ratio.
