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Why I pay close attention to the dividend payout ratio

Most dividend investors would say that the most important statistic when comparing companies is the dividend yield.

I think the dividend payout ratio is a very underrated metric that every investor should be aware of because of several different aspects:

Fuel for future growth

Businesses have three options to fund future growth. They can either take on debt, issue more capital or use retained earnings. Issuing capital dilutes existing shareholders and debt always makes a business more risky.

If a company is paying out most of its profit as a dividend then it doesn’t leave much to fuel future growth. It also suggests that the company doesn’t have much potential growth in its market.

That’s why a lot of large Australian businesses pay out so much of their profit, they have already saturated the market.

Companies that have a lower payout ratio tend to have a lot more growth prospects.

Dividend flexibility

Having a lower payout ratio means that a business can increase the dividend even if the business had one bad year. If a company is already paying out most of its profit then it could lead to a dividend cut to remain under a dividend payout ratio of 100%.

It also means that if a company decides that it doesn’t need to retain as much profit in the future it could, for example, change its payout ratio from 50% to 75% which could boost a company’s yield from 3% to 4.5%.

Sound management

I think having a relatively low payout ratio just shows that the current management of the business are thinking about the future of the business, not just providing as big of a dividend as possible over the next twelve months.

Management never know when an opportunity to acquire a business may come up. Management never know when a recession may hit. Management should have the confidence that they can provide shareholders better returns by holding onto some of the capital rather than paying it all out as a dividend.

Foolish takeaway

Franking credits are a big reason why companies are willing to pay out big dividends to shareholders. I think a dividend payout ratio of around 50% (or less) provides the balance between income and growth. However, I feel comfortable going up to a payout ratio of around 80% for the right dividend shares.

Companies like REA Group Limited (ASX: REA), Ramsay Health Care Limited (ASX: RHC), Challenger Ltd (ASX: CGF) and TPG Telecom Ltd (ASX: TPM) all have a payout ratio of 50% or less.

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Motley Fool contributor Tristan Harrison owns shares of Challenger Limited and Ramsay Health Care Limited. The Motley Fool Australia owns shares of Challenger Limited and TPG Telecom Limited. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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