As companies increase their revenues and earnings over time, management has to make the decision of what to do with their increasing earnings. I like the ones that pay out part of those earnings as dividends and take the other part and invest it in the business. If a company pays out none of its earnings as dividends, I’m not interested in that stock at all. If the company pays out all of its earning in dividends then it tells me that management doesn’t know how or is unable to grow the company. For the most part I’m not interested in these companies either. However there are exceptions to this for companies that produce huge amounts of earnings and pay a very large dividend. One such case is a company I discussed in the previous post “Prospect Capital Corp”.
Most companies that I’m interested in pay out part of their earnings in dividends and keep part of their earnings to grow the company. The part that they pay out in dividends can vary anywhere from 1% to 99% and this percentage is called the Payout Ratio. Companies that payout more than 70% are not desirable because they retain very little earnings to expand the business or develop new products. Companies that payout less than 20% had better have a great track record of using their earnings to increase profits going forward. I prefer companies that payout between 20% and 70% in dividends.
I also look at the growth rate of the dividend itself. If management is retaining part of earnings for the purpose of growing the profits of the company and they maintain the same payout ratio then the dividend should increase every year. I look for the dividend to increase at least at the rate of inflation. This rate of increase is necessary to maintain my purchasing power in the years ahead. If the cost of living is increasing at 3% per year, I need my stocks to increase their dividends by at least 3% per year to keep up with that cost of living. And more than the cost of living is better. I would like to think that in the future I will be making more relative to the cost of living than I’m making today.
I also expect to take those dividends and invest them back into those companies that are increasing my dividends going forward. I don’t subscribe to any dividend reinvestment programs because I prefer not to be locked into buying a specific stock. I prefer to invest dividends into companies that produce the best opportunities at the moment I receive the dividend which may or may not be the company that’s paying the dividend. It’s a level of control over my investments I’m unwilling to concede.
In the end, dividends are dependent on the revenues and earnings that the company generates, the payout ratio that management puts in place, and the annual dividend growth rate that enhances my future purchasing power. It’s all a trade off but as a general rule the farther out retirement is the lower the payout ratio and the greater the dividend growth rate the better. If retirement isn’t that far away then the higher the payout ratio and the less the dividend growth rate the better. It’s all a manner of life span. The older I get the more I want dividends now and the less growth I need in the future. The reason should be obvious.
Therefore the more an investor begins to understand all the variables involved in investing, the more he begins to understand how investing is connected to both the point he's at in his life as well as his expectations of when and how he'll spend his retirement. These are all individual decisions but they are things that have to be constantly considered and reevaluated. Otherwise there won’t be a retirement and I’ll end up working the drive thru window at the local hamburger joint.