High Dividend Yield vs. Low Payout Ratio

by Tim Plaehn
The investor's dilemma: high yield or dividend growth.

When you compare dividend stocks, high-yield stocks and low payout ratio stocks will be at the opposite ends of the spectrum. As an investor looking for income from your stocks, the high-yield option pays obvious dividends -- pun intended. However, the low payout ratio stock provides the potential for an increasing dividend over time and increasing dividends often result in higher stock prices.

Dividend Payout Ratio

The dividend payout ratio of a stock is the annual dividend divided by the earnings per share for the year. Consider the dividend policy of two companies, both of which earned $5 per share. Company A pays a $4 annual dividend for an 80 percent payout ratio. Company B pays $1 per year in dividends or 20 percent of the net income. Company A chooses to pay out most of its profits as dividends. Company B has elected to take most of its earnings and reinvest the money into the business.

Stock Value on Earnings

A measure of a stocks value is the price-to-earnings -- P/E -- ratio. Using P/E lets investors compare the relative value of companies in relation with how much money they make -- the earnings. Assume companies A and B are in the same industry and the market gives the stock similar valuation. Because both have the same earnings per share, the stock price will be the same at the same P/E. If the two example stocks are valued at a P/E of 10, each will be $50 per share. At this share price, company A is a high-yield stock with an 8 percent dividend yield. Company B, with its low payout ratio, yields 2 percent.

Growth vs. Yield

A stock with a high payout ratio and high yield has little in retained earnings to pay for growth in the business. An attractive high-yield stock will have steady earnings that allow the company to continue to pay the attractive dividend. There is little potential for this company to increase the dividend. The low payout ratio stock has more flexibility. The company can use retained earnings to grow the business, increase earnings and pay a bigger dividend next year. Another option for the low-payout company is to increase dividend payout rate. A higher dividend will attract more investors and possibly push up the share price.

The Trade-Off

The high-yield stock will pay the big dividend as long as there is not a drop in earnings, either because of bad business conditions or a troubled economy. The low payout ratio stock can continue to pay the dividend even if profits decline. With the low-payout stock, an investor chooses to accept the lower yield in exchange for a stronger guarantee the dividend will not be reduced and might possibly be increased.

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About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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