1 key ratio to check before you buy your next dividend stock

Investors in Singapore have a huge benefit from untaxed dividends. 

That makes our local stock market one of the best places to build a portfolio of dividend-paying stocks. 

However, not every stock is worthy of your investment dollars.

To help separate the wheat from the chaff, there is one simple ratio I look at to get a better handle of the attractiveness of the dividend stock: the payout ratio 

A SIMPLE RATIO TO WATCH 

The common goal of a dividend investor is to build a steady stream of reliable income. 

As such, we want to make sure that the companies that we invest in can afford to support the dividend that it is currently paying. 

To do so, we can check if these companies are paying its dividends using cash that it generates from its operations.

And that's where the payout ratio comes in.  

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We want a dividend that is well-covered by either earnings or free cash flow.  

The degree of coverage is measured by the payout ratio which is the amount of profits or free cash flow that a company decides to pay out as a dividend. 

In general, a lower payout ratio implies that the dividend is well-protected and sustainable while leaving room for dividend increases in the future. 

But there is more nuance to it. 

CONTEXT MATTERS

Mature companies with limited growth potential would be better off retaining less cash and paying it out as a dividend. Therefore, a higher payout ratio is preferable. 

Under this scenario, investors would get a good, steady dividend. However, they should not expect dividends to grow meaningfully in the future since there is not much cash retained for internal use.

On the other hand, if we have a company with a long runway of growth, we would want more cash to be retained - that is, maintain a lower dividend payout ratio - to grow the business. 

If the company is successful in growing, we should expect to receive higher dividends in the future.

GET SMART: NO ONE RATIO CAN RULE THEM ALL 

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Unfortunately, investing cannot be distilled down to a single ratio. If a company's profits fall, its dividends may eventually be cut. 

The payout ratio tells you whether the business can afford to pay the dividend today. But it does not tell you whether the company's earnings will grow, stagnate or decline in the future. 

It is not enough just to judge a company by one ratio alone. There are many other ratios and factors to consider.

This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice.