Dividend Payout ratio basically refers to the percentage of the earnings used to pay out Dividends. Ideally, Dividend Payout Ratio should not be too high, as a rule of thumb it should not exceed 85% for most Companies. The reason is that if most of the Earnings are paid out as Dividends, there would be little Retained Earnings left to support business growth. However, there are exceptions to these. Certain Stocks likes Real Estate Investment Trusts (REITS) and Business Trusts typically have Payout Ratios in excess of 90% or even 100%. REITs are required by law to Dividend out 90% of the Earnings to gain favourable tax treatment. Some Companies also have a very high Payout Ratio because they have high Depreciation and Amortization, which is non cash item. To see how sustainable the Dividends are, one would have to look at the Dividend Cash Flow Cover Ratio below.
Dividend Coverage Ratio
Dividend Coverage ratio is the inverse of the Dividend Payout ratio. It refers how many times the Earnings can cover the Dividends paid. Ideally, the higher the Coverage Ratio, the better it is. If Dividend Coverage is 2, it means that the Earnings can cover the Dividends twice and minor fluctuations to the Company’s Earnings should not affect Dividends paid out. One should avoid stocks which have Dividend Coverage below 1, it means that the Company does not have enough profits to cover the Dividends for the year and are paying out from Retained Earnings!
Dividend Cash Flow Coverage Ratio
Free Cash Flow = Operating Cash Flow – Capital Expenditures
http://www.investinpassiveincome.com/how-to-pick-a-top-dividend-company-for-income-part-3-determining-stability-of-dividends/
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