Why Dividend Stocks With Low Payout Ratios Can Be Better Than Those With High Yields

Dividend-paying stocks in the S&P 500 have historically outperformed their non-dividend-paying index peers. Dividend-growing companies in the index have performed even better.

So should we buy the highest-yielding dividend-growth stocks in the S&P 500 and call it a day?

Maybe, but there is one last (and less popular) metric that has historically led to outperformance — the payout ratio. Specifically, dividend-growing stocks that maintain a payout ratio below 50% help create the exact type of stocked pond people like to fish in, offering investors a healthy balance between returning cash to shareholders and funding company growth.

As a result, it’s not the top quintile of highest-yield stocks (and their 74% average payout ratio) that outperform at the highest rate, but the second quintile (and its 41% average payout ratio), according to data from Wellington Management.

Let’s find out what this means for investors interested in optimizing their dividend strategy.

Image source: Getty Images.

High-yield dividends, low growth prospects

While high-yield dividend stocks may be alluring at first glance, many tend to have higher payout ratios. The payout ratio is a stock’s dividend payout as a percentage of its net income, and it can quickly tell investors how much of a company’s profits are going directly back to shareholders.

When these high-yield stocks continue to increase their dividend payments over time, they eventually begin to test the limits of their financial security, paying out bigger portions of their earnings.

High payout ratios typically mean two things.

First, the company will have less money to reinvest back into the business, spending which could have fueled future sales growth, eventually growing the bottom line. Sales growth is a strong indicator of a stock’s long-term performance, putting companies with high payout ratios at a disadvantage thanks to their hampered growth prospects.

Furthermore, if a company has a high payout ratio, its dividend growth potential is similarly restricted — or worse yet, it may need to cut its payout to maintain financial security. While dividend cuts are far from death knells (sometimes even wise decisions), they generally lead to a sell-off in the stock as income-focused investors flee.

S&P 500 companies that cut their dividend not only underperformed their peers over a 48-year period but produced a negative annual return overall, reinforcing the importance of a well-funded dividend.

Low payout ratios, long-term growth potential

On the flip side, stocks with low payout ratios offer a balanced approach between returning cash to shareholders and funding future growth. Thanks to this extra cash available to reinvest in the business, a flywheel effect can take hold.

First, a portion of the excess profits go back into the business, creating new sales that flow through to the bottom line. With this rising net income, the company can increase its dividend, often without raising its payout ratio as profits and dividends paid out rise at a similar rate.

Additionally, if the company still has earnings to spare, management can also consider lowering its share count through share repurchase programs. For example, consider the declining share counts for two great low payout ratio stocks, Lowe’s and Union Pacific.

Data by YCharts.

Despite the capital required to maintain their respective operations, these two have not only funded many years of annual dividend increases but rapidly lowered their total shares outstanding over the last decade. Fewer shares make the dividends cheaper to maintain while boosting earnings per share — furthering the flywheel effect.

Because of these benefits, looking for low payout ratios over high yields is akin to choosing longer-term cash flow potential over higher near-term income.

The best of both worlds

Best yet for investors, a handful of stocks offer relatively high dividend yields and low payout ratios. Let’s look at three here:

Dividend yield
Payout ratio
Maximum dividend potential
Consecutive years of dividend increases

Source: Yahoo! Finance. Maximum dividend potential = dividend yield/payout ratio.

Notice that despite not having the highest dividend yield, Intel has the highest maximum dividend potential based on its dividend yield divided by its payout ratio. Similarly, Target has a dividend yield about one percentage point lower than Cummins, but they have comparable maximums.

I bring these three companies up to illuminate the power of a low payout ratio. Yes, you may be sacrificing some near-term dividend income by forgoing high-yield stocks, but your long-term dividend potential should one day dwarf that high initial income if you hold for the long haul.

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Josh Kohn-Lindquist has no position in any of the stocks mentioned. The Motley Fool owns and recommends Intel. The Motley Fool recommends Cummins, Lowe’s, and Union Pacific and recommends the following options: long January 2023 $57.50 calls on Intel and short January 2023 $57.50 puts on Intel. The Motley Fool has a disclosure policy.

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