Why Understanding a Dividend Payout Ratio is So Important

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Investing in the right dividend stocks is a reliable way to generate income for years on end. However, not all dividends are created equal. Looking at a stock's payout ratio is one way to get a better idea of how sustainable the company's dividends are and whether it is a sound investment that will line your pockets with cash well into the future. It is in this spirit that we will take a closer look at why the dividend payout ratio is one of your best resources when vetting potential dividend paying investments.

What is a payout ratio?
The dividend payout ratio is a financial term used to measure the percentage of net income that a company pays to its shareholders in the form of dividends. The payout ratio is important because it tells investors how much of the company's profits are being given back to shareholders. Put another way, a payout ratio of 20% means for every dollar the company earns in net income, 20% is being returned to shareholders as a dividend.

However, if this number is too high it could force said company to cut its dividend down the road. Rural telecom giant Windstream Holdings for instance, has a payout ratio of 344. This means it pays out more in dividends than it currently produces in net income. Not to mention, management doesn't have any cash left over to sensibly invest in growing the business. Translation: Windstream's dividend isn't sustainable.

Too often, investors are lured into dividend stocks that boast the highest yields. Windstream, after all, flaunts a dividend yield of 10.05%. That is particularly attractive considering the S&P 500 has an average yield of just 1.99% today. However, in reality, a dividend with a sky-high yield that might disappear tomorrow is far less valuable to investors than a dividend growth stock that will reward investors for decades with a reliable payout.

Why it matters
Procter & Gamble
is one of many stocks today that demonstrate how sustainable quarterly payouts compounded over long periods are one of the smartest ways to build wealth. For starters, the consumer goods company has a reasonable dividend yield of 3.08%. While this is well below Windstream's 10% yield, it is significantly higher than the S&P 500. And unlike Windstream, P&G generates more than enough cash flow to grow its dividend payouts for years to come, while also having enough money left over to reinvest in its business.

Perhaps, more exciting, Procter & Gamble has increased its dividend every year for the past 58 years straight at a compounded rate of more than 9% annually. Throw in the stock's payout ratio of just 58%, and you have a company that should be able to not only continue paying a dividend, but also raise its payout for many years to come. In this case, Procter & Gamble's payout ratio indicates that the company is both rewarding shareholders while also investing in future growth.

In conclusion, investors should be cautious of payout ratios over 100% because this means the company is giving away more than it earns. Over time, this is unsustainable. Therefore, a good starting point for investors is Dividend Aristocrat stocks because these companies have increased their payout for 25 consecutive years or more. Not to mention, most dividend aristocrat stocks such as Procter & Gamble possess payout ratios under 60%, thereby offering investors high dividend growth with less risk.

Introducing the safest dividend stocks money can buy
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here.

The article Why Understanding a Dividend Payout Ratio is So Important originally appeared on Fool.com.

Tamara Rutter has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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