One of my pet peeves as an investor is the financial media’s love of “earnings” or “net income”. Earnings are not a good way to measure a business’ success. They are often volatile and manipulated by management for short term gain or saving face. In fact, as a finance student, the first thing you learn about is cash flow. In this post I intend to show you with an example that you should ignore net income based payout ratios completely because they’re awful and cause investors to miss out on incredible opportunities.
What are Dividend Payout Ratios?
First let’s define what a payout ratio is. A dividend payout ratio is a measure of the ability to pay dividends from some source. Two common payout ratios are Net Income Payout Ratio and Free Cash Flow Payout Ratio. In both cases, the lower the number, the safer the payout ratio is.
Net Income Payout Ratio is defined as Dividends divided by Net Income.
Free Cash Flow Payout Ratio is defined as Dividends divided by Free Cash Flow.
Now that we’ve defined these terms, let’s jump straight into a great example of where investors that used net income based ratios would have considered a solid stock as risky, Broadcom.
The chart above shows free cash flow payout ratio in purple and net income payout ratio in green. As you can see the green line is volatile and somewhat unpredictable. Additionally, the payout ratio is well over 100% indicating to a naive investor that the dividend is unsafe!
However, if you look at the Free Cash Flow Payout Ratio, it is both stable and “safe” at below 50%.
The reasons for this disparity are simple. Most business managers are often incentivized by earnings. If a one time non-cash expense occurs, it’s often better to take a “big bath” and lump in accumulated expenses into one quarter. You can see that happened twice with Broadcom in 2016 and 2017.
Worry about Cash Flow
The gist of this article is that income is a story, cash flow is the truth. Investors should only care about the truth and remember that cash flow is king.
My next blog post will cover REIT Payout Ratios, FFO and AFFO since Free Cash Flow doesn’t always tell the story with them either!
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