Payout Ratio for Retirement Income Investors

In my previous article on retirement income investing, I explained the basics of the three sections of the Statement of Cash Flows that relate to the main cash flow activities, operations, investing and financing.

In this article, I will describe how to find the information from the statement and calculate payout ratios, which will help investors determine whether an equity should be able to sustain, or potentially raise, its dividend distribution.

Due to the standardized reporting requirements under the Generally Accepted Accounting Practices (GAAP), it is unusual for a company to try to manipulate these numbers to enhance the reported Net Operational Cash Flow. However, some managers have done it and few more have attempted it. The SEC has investigated cases of usually misclassifying an operational expense as an investment activity as a way of artificially increasing Net Operational Cash Flow.

Netting out the three cash flow activities — operations, investing and financing — will show how much the company’s cash in the Cash & Cash Equivalents (C&CE) account has increased or decreased for the year. Just like your checkbook, this must balance. This net amount of C&CE will be carried over to the company’s balance sheet for the end of the fiscal year. Although the C&CE is usually not factored into a company’s cash flow and dividend coverage analysis, it could be if it is large at the beginning of a given year.

For example, Verizon (NYSE:VZ), ended 2017 with $50,498 Million in C&CE which is the amount they began 2018 with. At the end of 2018 they show $5,400 Million in the C&CE account, thus they used $45,098 Million in 2018 to pay a large part of a telephone company acquisitions.

A large part of these funds is most likely going to be used for some capital acquisition in the following year. Most dividend-paying companies will carry a C&CE base balance year-to-year and will use it only for smoothing out cash flow peaks and troughs during the year. These companies will generally not use the C&CE base balance as a savings account to pay for future capital expenditures, as the interest on a large C&CE balance would be minimal compared to what they could be getting by investing that cash.

Where can you find the cash flow data on a given security you are considering owning? The company’s most recent 10Q and 10K filings that are generally available on the company’s website are the best places to start.

The table of contents on these statements will show the consolidated financial statements within which you will find the Statement of Cash Flows. It might take some experience to easily navigate a financial statement. If the company’s web site is not user friendly, one could go find a “Free Edgar” and type in the stock symbol and then go down the list of filings to find the most recent 10Q and 10K.

However, a much easier way is to use the free service provided by Morningstar, MarketWatch or Bloomberg, to name a few. At their web site, type in the symbol and when the security’s information comes up, click on “Financials” and then click on “Cash Flows.” You get for free the cash flow history for the past five years. You will have to pay for premium membership at Morningstar to get the 10-year history. Alternatively, you can go to https://amigobulls.com where you can get up to 23 years of quarterly or annual statements in 5-year blocks. You will have to register to access the data, but the registration is free. However, the history for the previous 10 periods — quarters or years — is sufficient for most cases. I am sure that there are other sites that will provide this information as well, but I am most familiar with the services mentioned above.

In the calculations below, I copy and paste the values from the financial statements as they appear on the Morningstar’s web site. A very nice feature with Morningstar is that even though some values on the Earnings Statement are organized horizontally, when you copy and paste the horizontal values into Excel, they are reorganized vertically. Additionally, Morningstar offers a feature to download the entire financial statement into Excel, where you can then manipulate and rearrange the values for use in your calculations.

Now that we have a basic understanding of the Statement of Cash Flows and its significance for retirement income investing, it is very easy to use the free information to determine a company’s ability to pay its dividend. To calculate the payout ratio, we must divide the total dollar amount of the dividends paid by the total CFFO. The best way to illustrate the process is to use an example. Let us use Walmart (NYSE:WMT).

Going to the Morningstar website, I entered the WMT ticker symbol and, once on the company’s page clicked on “Financials,” then “All financial data” and finally selected “Cash Flow” from the three available financial statements.

Once in the cash flow statement, find the total dollar amount of the dividends paid in the “Net Cash Flow from Financing Activities” section. For 2017, you will find a 6,216 number in brackets which denotes a cash outflow or a payment. The numbers reported are in millions. Therefore the 6,216 number represents $6.216 billion. Next locate the “Net cash provided by operating activities” line item and you will find 31,530.

Dividing the dividends paid by the CFFO gives us:

This means that the company used 19.7% of the CFFO to pay that year’s dividend. This ratio is on the low end of the acceptable range for such a large Fortune 100 company, whose peers’ dividend-to-CFFO payout ratio usually runs around 20%-25%.

Let us try another example. The Wisconsin Energy Corp (NYSE:WEC) is an electric utility and from the 2017 Statement of Cash Flows for WEC available on Morningstar we find the information listed below — reported in millions.

Dividends paid:                        $657

Net Operational Cash Flow: $2,080

Dividend-to-CFFO payout ratio:

This also is an acceptable dividend-to-CFFO payout ratio.

In my experience, acceptable payout ratios vary by the stocks within an income class. Although I have no scientific basis for this, here are some Dividend-to-CFFO ratios I have found that I consider satisfactory:

     C-Corporation non-cyclical and consumer staple stocks: <30%

Utilities: <50%

 REITs: <80%

 MLPs: <80%

A payout ratio that exceeds these values does not necessarily rule out that stock, but it does put it in a higher income risk group. After you analyzed many equities, you will get a feel for a good ratio, what is acceptable and what is excessive. However, more important than the actual ratio is the trend in these ratios. That is what retirement income investors want to know. This is like the way we look at the trend in dividend growth. Therefore, we will look at the dividend coverage trend in a future article. However, in the next retirement income article, I will discuss another retirement income equity selection factor: Return on Invested Capital (ROIC).

Bruce Miller is a certified financial planner (CFP) and retirement income expert who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.