4. Dividends and payout: high is not always good

Theory 3: Asset classes and how to read a company

You see a stock paying six percent a year in dividends. That can be excellent news. Or it can be the warning that the dividend is about to disappear.

We have mentioned several times that paying dividends is a company decision, not an obligation. In this module we go deeper into how to evaluate that decision with judgment, because 'high dividend' is probably the most misread signal in all of equity investing.

One percentage, two opposite stories

The dividend yield is calculated by dividing the annual dividend per share by the current share price.

A dividend yield of 6% sounds attractive next to the return on a bank deposit. But that figure can rise for two radically different reasons:

• Because the company has increased the dividend. Generally a good sign.
• Because the share price has fallen sharply while the dividend has stayed the same. A possible warning sign.

Hence a practical rule worth internalizing. An unusually high dividend yield relative to the rest of the sector, with no increase in the dividend in euros, is almost always a warning. It is the market anticipating that the dividend is not sustainable and will probably be cut soon.

The price has already fallen because other investors reached that conclusion before you did.

The payout ratio: how much headroom is left

The payout ratio — the percentage of net income used to pay dividends — is the main tool for judging the sustainability of a dividend.

Three levels tell three very different stories:

• A payout ratio of 40% leaves the company considerable headroom. It can keep paying the same dividend even if profits fall moderately for a quarter or a year.
• A payout ratio of 95% means almost all of the profit goes to the dividend, leaving very little room. Any deterioration of the business directly threatens the continuity of the payment at its current level.
• A payout ratio above 100% means paying out more in dividends than is earned in net income. It is not sustainable indefinitely without funding it with debt or accumulated cash.

That last case is usually a sign that management is prioritizing the perception of stability among investors over financial prudence.

Growth or maturity: the right payout is not the same

It is also worth distinguishing between growth companies and mature companies when judging dividend policy.

A growth company with attractive reinvestment opportunities is usually right not to pay a dividend, or to pay very little. We mean opportunities such as opening new business lines, expanding into new markets or funding R&D with high expected returns.

The reasoning is direct: each euro reinvested in the business, if the opportunities really are good, creates more long-term shareholder value than that same euro paid out and spent.

A mature company, with few attractive reinvestment opportunities inside its own business, is right to return a substantial part of its profit to shareholders. Via dividends or via buybacks, as we saw in the first level.

The reason is the symmetrical one: holding cash with no clear productive use creates no added value, it just piles up an unproductive asset on the balance sheet.

Neither too much nor too little: it depends

The practical conclusion is that neither 'pays a big dividend' nor 'pays no dividend' is, on its own, a good or bad sign. It depends entirely on context.

A high but sustainable payout ratio in a mature, stable company is perfectly reasonable. The same payout ratio in a company with volatile earnings is a fragility waiting to show itself.

And the complete absence of a dividend is not necessarily bad news either. In a company that reinvests with judgment and generates high returns on that reinvested capital, it may be precisely the decision that creates the most value over the long run. At least for whoever has the patience to wait for it.

The dividend aristocrats, and why they are not enough

One category often cited as a benchmark of reliability is the 'dividend aristocrats'. These are companies that have increased their dividend in euros, year after year, for at least 25 consecutive years, including recessions and severe financial crises.

Belonging to this category guarantees nothing about the future. No past streak, however long, obliges a company to keep it going.

It is, on the other hand, a reasonably strong sign of a corporate culture that treats dividend stability as a commitment to shareholders. Something a single quarter's payout ratio cannot convey on its own.

In any case, neither this category nor any other shortcut should become a substitute for analysis. The relevant question is always the same: does this business sustainably generate the profit needed to keep paying what it promises?

And no past track record answers that question with absolute certainty about the future.