The Myth of Dividend Payout Ratio Part I: Is Lower Necessarily Better?

Everywhere I look for dividend investing commentary I always read the same "absolute truth": a lower dividend payout ratio is better. It's almost a dogma among dividend investors.

Intuitively, it makes sense.

The payout ratio is the portion of earnings that a company pays out as dividends. So, if you expect your dividends to be paid consistently and to not be cut or shrink over time, a low payout ratio makes sense: there's a margin of safety; if the company earns less one year, it will still be able to pay its dividend if the payout ratio is low.

The idea of "low payout is better" then is that companies can smooth their dividends if they retain cash for a rainy day and allow ample room for earning shrinkage by paying out less of their earnings in dividends.

So what's wrong then?

Well, two things. One is a principle thing and the other one is a historical fact:
  • In principle, all money not needed to be reinvested in the business (to keep the business afloat, such as replacing inventory, fixing up plant and equipment, etc) belongs to shareholders. So, management has no moral right to keep more than they should of shareholders money.
This can be debatable, especially if each dollar retained by the company gets translated to an extra dollar of appreciation of their share price.

As for the the historical fact:
  • Historically, smoothing out earnings hasn't provided any evidence that it can prevent or reduce the likelihood of dividend cuts. Consistent dividend growth and reliable payouts are the exception, not the rule.
At least that's what Ben Graham's investment company found out after many years of market research. The results are in Graham's book, Security Analysis. Consider this passage:
The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future profits has been hailed with such enthusiasm as to advance the price of the stock. The direct opposite has invariably been true. Given two companies in the same general position and with the same earning power, the one paying the larger dividend will always sell at the higher price.
(Security Analysis, 4th edition, Benjamin Graham and David Dodd, 1940)
The authors go on to explain that the theory of lower payout ratio may sound good, but that it fails to provide adequate protection regarding dividend cuts, and that therefore dividends should just be paid out as much as possible and it's the investor who should worry about smoothing his earnings over time.

This smoothing can be achieved by investors by them not relying on a fixed and increasing income stream from a dividend portfolio but instead relying on a fraction of it and saving the rest for a rainy day.

If the investor is not depending on the income stream for a living, then it's even better to get the maximum dividend now instead of later since an intelligent investor will have an easier time allocating the income proceeds into the most interesting investment opportunities at any given time than would individual companies.

In the book, Graham shows a few examples of companies that attempted to smooth out their dividends just to cut them some years later.

In another post, I will go over a current example where the smoothing out of dividends was detrimental to shareholder's returns.

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