Dividends: yield, payout and safety

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Key idea: A high dividend yield is only attractive if cash flow can keep paying it. The payout ratio tells you how stretched the dividend is.

Dividend yield is the yearly dividend divided by the share price. A $2 dividend on a $50 share is a 4% yield.

A very high yield is often a warning rather than a gift. Yields rise when prices fall, and prices often fall because the market doubts the dividend will last. A 9% yield on a struggling company can quickly become a 0% yield after a cut.

The payout ratio is the dividend divided by earnings, or better, by free cash flow. A company paying out 50% of its free cash flow has room to keep paying in a bad year. One paying out 120% is funding the dividend from savings or borrowing, which cannot last.

Also look at the record: years of steady increases through recessions say more about a management team's commitment than any single year's yield.

Quick check

A company pays $3 a share in dividends and earns $2.50 a share in free cash flow. What is the main concern?

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