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WHY THE PAYOUT RATIO CAN BE MISLEADING

By Scott Chan • September 9, 2024 • Stocks to Watch

Printable PDF

The payout ratio is a common metric that investors study to try to analyze a
company’s dividend outlook. The formula is straight forward: divide the dividend
paid by net income. It seems to make a lot of sense.

The better a company’s profits cover its dividend obligation, the more likely it
should be able to pay out the same dividend, or increase it, in the future. One
of the surest ways to build wealth (and protect your portfolio) over the long
term is to invest in stocks with demonstrable dividend growth.

A high payout ratio is a warning sign. It means that a company is paying out a
big chunk of its earnings to shareholders. This could mean less room for
dividend growth or that the current dividend level is unsustainable.


EARNINGS NOT THE SAME AS CASH

However, it’s very important to realize that earnings as reported on the income
statement is not a perfect reflection of how well a company can cover its
dividend. After all, a company pays out dividend in cash, which is not the same
as earnings.

You see, U.S. companies report their financial results under GAAP (generally
accepted accounting principles) rules, which require the use of the accrual
accounting method.

Consider the following simple scenarios as an illustration of why this matters.

Company A buys 10 office chairs from Company B for $10,000 and pays for the
whole thing on the day of purchase. This is straight forward as Company B
receives the cash at the same time that it records the sale. No problem here.

But imagine that instead of paying right away, Company A buys the computers on
credit and will pay for them at a later time. Under GAAP rules, Company B has to
record the revenue on the date of the sale even though it hasn’t received the
money. Ideally, Company A will pay off 100% of what it owes Company B, but it’s
also possible that it never fully pays the entire $10,000.

Under the second scenario, Company B would show $10,000 in revenue, and the
profit/loss calculation would be based off this $10,000 figure. Let’s say its
total costs were $8,000, so its profit would be $2,000. But in reality, it does
not yet have any cash. So imagine you were basing your dividend expectations
solely on that $2,000 accounting profit!


ACCOUNTING DECISION CAN MUDDLE PICTURE

Obviously, the simple example is not realistic because a real-world company
wouldn’t be relying on only one sale and it would have access to financing to
meet its cash needs, and so forth. But the point is that earnings figures can be
misleading because they don’t always accurately reflect the financial shape of a
company.

In real life, companies have some flexibility when they recognize revenue and
expenses. For example, in multi-million-dollar deals involving complex projects
that span years, when to recognize revenue and expenses is not always
straightforward. A company’s decision can significantly impact its financial
numbers. It’s not unheard of for a company to be aggressive in recognizing
revenue to make quarterly reports look better to shareholders.

Another common management decision that can materially create distortions
between earnings and cash flow is which inventory accounting method to use.

U.S. GAAP gives companies the freedom to choose whether to use the FIFO (first
in, first out) or LIFO (last in, last out) method in accounting for the value of
their inventory.


FIFO? LIFO?

Let’s go back to the example of the office chairs to show the difference between
FIFO and LIFO accounting. Say Company B has 1,000 identical chairs in stock, and
500 of them were bought one year ago at $50, and the other 500 were bought six
months ago at $75. If Company B sells 500 chairs from inventory, under FIFO the
500 chairs purchased one year ago at $50 would be considered sold. Under LIFO it
would be the 500 units bought six months ago at $75.

In the first case, the cost of goods sold would be $25,000 ($50 x 50) and the
value of the remaining inventory would be $37,500. But under LIFO, the cost of
goods sold would be $37,500 and the value of the remaining inventory would be
$25,000.

Even though Company B would receive the same amount of cash for the sale of the
chairs under FIFO or LIFO, the expenses (and thus profit) would actually be
different!

It should be clear now that a company’s earnings does not tell the full picture.
This does not mean that the payout ratio is useless. Quite the contrary. It is
still a helpful ratio to check out, especially if you compare it with those of
the company’s peers and compare it to the company’s own history. The point,
though, is that you should not look at the payout ratio in isolation. It’s a
good starting point, but you have to study a company’s numbers more closely to
truly get a good picture of where it stands.

Editor’s Note: Scott Chan just provided you with invaluable investing advice. If
you’re looking for new sources of profits, you should consider marijuana. That’s
right…marijuana.

Weed is no longer a pariah and counter-cultural act of rebellion. It’s a
multibillion-dollar bonanza. Investors who ignore pot stocks will miss out on
huge, market-thumping gains.

Through painstaking research, my colleague Jim Pearce has discovered that a
small group of everyday Americans are earning up to $51,338 a year from one
company’s lucrative marijuana profit-sharing “plan.”

Jim is the chief investment strategist of our flagship publication, Personal
Finance. He tells me that this particular company is the biggest win-win
opportunity he’s ever seen in the marijuana market.

There’s one step you must take to qualify for the next round of payouts. To
learn more, click here now.

 


ABOUT THE AUTHOR

Scott Chan
Bio | Archive

Scott Chan moved from China to the U.S. with family at the age of ten. He passed
the rigorous entrance exam and attended the merit-based Stuyvesant High School,
widely held to be best public school in New York City. He earned undergraduate
degrees from New York University followed by an MBA degree from the Zicklin
School of Business at Baruch College.

Shortly thereafter Scott partnered with Dr. Stephen Leeb on numerous financial
publications. Today, he serves as the lead analyst for Real World Investing and
The Complete Investor.

Mr. Chan is an avid baseball fan and enjoys outdoor activities in his spare
time. A multicultural person, he reads Chinese and speaks fluent Mandarin and
Cantonese Chinese.

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