I was just going over some of my sector-based watch lists and was struck by the wide variety of dividend payout ratio targets that have been set by companies. This got me thinking about how often investors, and specifically dividend investors, use payout ratio as an initial screening tool for finding potential investments.

Not only do payout ratios vary significantly from sector to sector, but they also can vary significantly between companies operating in similar businesses. For example, it is quite common for utility companies to pay out more than 50% of their earnings in dividends, as they operate in generally stable businesses that have predictable earnings. However, when looking at my 30 stock utility watch list, there is a range of targeted payout ratios from 40-75%, with UGI Corporation $UGI on the low end and Dominion Resources $D at the top.

Intuition might cause one to assume that Dominion’s higher payout ratio makes it less likely to grow the dividend, yet I’m projecting the same 8% dividend growth rate for Dominion that I am for UGI.

On the consumer staple side you have a company in Altria Group $MO that has a targeted payout ratio of 80%, has grown the dividend at an 11.6% annualized rate over the last decade, and should see 8-10% growth going forward. Counter that with Kellogg Company $K, which has a targeted 40-50% payout ratio yet has only grown at 6.4% over the last decade with 3-4% growth expected going forward.

Altria has double the payout ratio yet also has more than double the expected growth rate. Which one would you rather own?

In the industrial sector you have Deere & Company $DE that had a “safe” targeted payout range of 25-35%, yet has frozen its dividend for the last 11 quarters. Meanwhile 3M Company $MMM has a 50% target yet should see 7-8% growth going forward. Both are paying out slightly more than 50% of earnings right now; which one do you think will grow dividends more quickly going forward?

What it boils down to is that the dividend payout ratio should not be looked at in a vacuum, as it neither tells you where the dividend has come from nor where it will go. It needs to be looked at on a company by company basis and taken in context with many other factors.

Here are some of the main things I look at with payout ratios:

• Where is current payout ratio in relation to the target set by management? Often times management will provide guidance if they are expecting higher growth to raise the ratio to a higher level, or if they are planning to match earnings growth going forward.
• Is the company seeing earnings growth that keeps up with dividend growth, or has the payout ratio expanded beyond normal historical levels? This issue is more prevalent in cyclical sectors. In the case of Deere, the payout ratio has ballooned to more than 50% as earnings have been cut in half during the recent downturn.
• What type of business is the company operating? As mentioned, a utility will likely have a higher payout ratio than an energy company, and a consumer staple will likely have a higher payout than a consumer discretionary. Keep the sector and business of the company in mind.
• What is the financial strength of the company? A company with a AAA credit rating is more likely able to withstand a higher payout ratio than a BBB- or lower rated one. I’m less concerned with a company like AA- rated Coca-Cola $KO having a ~70% payout ratio than I am with BB+ rated Gap Inc. $GPS and its ~50% ratio. Buy Quality, Quality, Quality!

In summary, my simple advice is to be careful when using dividend payout ratio as a screening tool. A low payout ratio doesn’t really mean anything more than a high one does. It is the health of the business behind it that determines whether or not the dividend is safe or will continue growing.

By setting your screening target too low, you may be missing out on some great companies for your portfolio.