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3 Risks You Can't Ignore - Dividend Payout Ratios | Investing 101 - YouTube
Channel: Let's Talk Money! with Joseph Hogue, CFA
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There are three major risks to a stock’s
dividend payout ratio that WILL mean the difference
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between solid returns or big losses.
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In this video, I’ll not only explain the
dividend payout ratio, I’ll reveal those
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three payout ratio traps and how you can be
a better investor.
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We’re talking dividend payments today on
Let’s Talk Money!
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Beat debt.
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Make money.
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Make your money work for you.
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Creating the financial future you deserve.
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Let's Talk Money!
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Joseph Hogue with the Let’s Talk Money channel
here on YouTube.
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I want to send a special shout out to everyone
in the community, thank you for taking a little
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of your time to be here today.
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If you’re not part of the community yet,
just click that little red subscribe button.
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It’s free and you’ll never miss an episode.
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We’re in the middle of a series of videos
on dividends and anyone in the community knows
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I’m a huge fan of these cash flow stocks.
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Research upon research has shown that dividend
stocks tend to do better than other investments.
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Probably the most famous, we see here research
by the Ned Davis firm that over nearly four
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decades, dividend stocks returned an annual
rate of 7.2 to 9.5% compared to a return of
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just 1.6% on stocks that didn’t pay a dividend.
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But one of the most important concepts in
dividend investing isn’t well known by most
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investors.
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This metric goes to the very heart of a company’s
dividend payment and its ability to keep paying
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or even grow that dividend.
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Ignore this measure and the risks we’ll
talk about and just wait for that stock to
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collapse because it will happen if you don’t
know what to watch for.
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We’re talking about the dividend payout
ratio and this is simple the percentage of
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the company’s profits it pays out as a dividend.
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I’ll show you two ways to calculate the
payout ratio in a moment but basically it’s
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just the dividend divided by a company’s
earnings, it’s net income.
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Now if we look at the two sides to the payout
ratio, you’ll see just how important it
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is and maybe even start to see some of the
risks we’ll talk about.
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Dividends paid by a company are a big responsibility,
it’s a commitment not only to make a current
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payment but most investors see it as a commitment
to make future payments as well.
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All you need to do is look at any company
that’s cut its dividend payment and watch
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the stock price to know how important that
forward planning for cash flow is for a company.
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On the other side of the dividend payout calculation
is just as important, the company’s earnings.
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Stocks are an ownership on those earnings
so this is directly related to a stock’s
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value and it’s price.
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Now I want to show you two simple ways to
calculate the dividend payout ratio but first
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I need your feedback on something.
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I asked in an earlier video if you wanted
to see more dividend or growth investing videos
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and the response was overwhelming to dividends.
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So I’m planning more on how to invest in
dividend stocks but what are the ideas you
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want me to cover?
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What are the dividend stock measures or strategies
you want to hear about.
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So scroll down and let me know in the comments
below the video.
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The payout ratio is super easy to calculate
and a couple different ways you can do it.
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Some websites or even the company’s financial
statements may tell you the dividend payout
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ratio but it’s so easy to calculate on your
own, I like to double-check the numbers anyway.
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The first way to find the payout ratio is
just to go to a company’s financial statements,
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so here we are on the Apple stock page on
Yahoo Finance and we’ll click on Financials
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in the menu.
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This will take us to the three financial statements.
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The income statement shows the sales and profits
of the company over either a year or three
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months.
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The balance sheet shows us the company’s
assets and debts at a point in time and the
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cash flow statement shows us the actual cash
in and out of the company over a year or three
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months.
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These three statements are something we’ve
talked about on the channel and you know I’m
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a big believer in using this Statement of
Cash Flows rather than the income statement.
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Most investors get caught up in those sales
and earnings on the income statement but these
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are all manipulated by management to make
the company look as profitable as possible.
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It’s much harder to bias those cash flow
numbers because it’s actual cash accounting
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and in fact, this is where professional analysts
spend most of their time, looking at those
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cash flows.
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Anyway, so we’ll first click over to the
cash flow statement and make sure it’s set
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on annual here.
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Then we’ll come down here to Dividends Paid,
so this is the annual amount Apple paid out
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as dividends in this year and this number
we see is in billions of dollars.
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So the company paid out $11,561,000,000 in
dividends this last fiscal year.
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Now we’ll scroll back up and click over
to the income statement which will show us
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the net earnings for that year.
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Here we’ll look for this Net Income from
Continuing Operations or Net Income Available
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to Shareholders and we see it was $53,394,000,000
for the year.
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So we’ll open our calculator and if we take
our eleven billion in dividends paid and divide
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by the fifty-three billion and change in net
income for the same period, we get a dividend
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payout ratio of about 22% for Apple during
that year.
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Now this payout ratio is going to fluctuate
a few percent from year to year so you should
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really take an average over a few years but
either way gives you a good idea for comparison.
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Another way to find the dividend payout ratio,
and it really makes no difference which way
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you use, is to do it on a per share basis.
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So here we’re on the Apple stock page again
and we see that Apple pays $2.92 a year per
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share in dividends.
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Understand this is a forward dividend so the
current quarterly dividend times four.
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Now we need the per share net income or earnings
so we scroll down to this Earnings graphic
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and we see each of the last four quarters.
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We can use this method anywhere you find per
share dividends and earnings so not just Yahoo
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but the site makes it really easy.
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First we’ll add up each of these quarters’
earnings to get the full year number and we
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get earnings per share of $12.16 over the
last year for Apple.
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Then we just take that $2.92 in dividends
and divide by the earnings for a dividend
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payout ratio of 24%.
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Understand this is going to be slightly different
than the other method because you’re using
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the current dividend times four so dividends
over the next four quarters and using the
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last four quarters in earnings.
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Technically, you should find the last four
quarters in dividends but this will give us
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an estimate that’s as close as we need for
comparisons.
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Now that we have the payout ratio for a stock,
I want to reveal three risks to looking at
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this you can’t ignore.
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These three ideas are going to be critical
to using the dividend payout ratio and picking
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the best stocks.
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First though, if you’re likin’ the video
and think it’s some useful information,
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do me a favor and tap that thumbs up button
or consider sharing it with another investor.
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The first risk you want to watch for in the
payout ratio is a company paying out too much
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of its earnings as a dividend.
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I know we all love dividends and it’s great
seeing that high yield but there’s a tradeoff
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you need to watch.
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A company paying out most of its profits as
a dividend isn’t going to have much left
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to grow the business, to grow those earnings.
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Now we know that the share price of a company
is based on those future earnings, that’s
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what you’re investing in is a share of those
profits.
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If earnings aren’t going to be increasing
or worse yet might decrease because the company
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hasn’t spent enough to stay competitive,
then that stock price could suffer.
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Obviously, it does no good to collect a juicy
10% dividend yield on a stock if the share
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price falls by 15% during the year or over
a period.
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Of course the question becomes, how much of
earnings can a company pay out before it starts
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limiting growth?
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For this you can start by just comparing it
to the dividend payout ratio for other companies
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in its industry.
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Remember, and this is extremely important
in a lot of investing ideas, you always want
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to compare a company with others in its industry,
not just with all other stocks or other companies
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outside the industry.
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Here we see a few industries and their payout
ratio.
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This is data collected by Professor Damadaron
of the Stern School at NYU, a great resource
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for investors and you can see how much some
of the industries differ on their payout ratio.
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You’ve got household products and utility
companies that pay out the majority of their
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earnings some even more than their earnings
as dividends.
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Then you’ve got the biotech drug industry
that almost pays no dividends at all.
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Think about this from a management perspective.
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The growth prospects are more limited in older
industries like household products or in regulated
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ones like utilities.
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Debt is very easy to come by for these industries
with stable cash flows so they can pay out
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lots of dividends and borrow if they need
more money.
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On the other hand, industries like biotech
and semiconductors, it’s all about reinvesting
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in research and development to create new
products.
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Debt is more expensive because sales and profits
are more volatile so these companies need
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to keep more of their cash back instead of
paying it out as dividends.
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This is why you absolutely must compare companies
with others in their industry.
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This goes for not only comparing the dividend
payout ratio but other metrics like price-to-earnings,
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dividend yield, and sales growth as well.
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Comparing a payout ratio with the industry
average, you start to do some analysis.
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If they’re paying out more, is it going
to be at the expense of growth.
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If they’re paying out less, does that mean
the company will grow faster or is it an opportunity
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to increase the dividend?
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You can also compare a company’s payout
ratio with it’s own history, so going back
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to look at how the payout ratio has changed
and how that has affected sales growth.
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The second place you need to look when you’re
looking at dividend stocks and payout ratios
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is whether the payment is supported by cash
flows.
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Dividend payments and a share buyback program
can be a big drain on cash and can turn into
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a problem if that cash flow evaporates.
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In fact, this is what happened to Warren Buffett
in his IBM investment, one of the worst investments
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he’s ever made.
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Buffett started buying shares in IBM in 2011
seeing a cheaper share price and chasing that
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high dividend yield.
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The company also had a huge share buyback
program that was boosting its earnings per
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share.
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The problem was, and for this we look at the
Statement of Cash Flows again, it was paying
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for all this with lots of debt.
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If you go down to where it says Common Stock
repurchased and Dividends paid on the cash
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flow statement, we see that IBM was burning
through about $18 billion in cash through
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the dividend and buyback each year.
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Now you look a little further down to where
it says Free Cash Flow.
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This is the cash generated by the business
that Operating Cash Flow and minus capital
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expenditures which is cash invested in equipment
and other things to keep the company running.
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So this Free Cash Flow is a measure of how
much cash is left over after reinvesting enough
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to keep the company stable and you see that
it was well under that $18 billion for all
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five of these years.
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So IBM was spending all this cash buying back
its own shares and paying out a dividend and
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it was paying for it by just piling on the
debt.
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If you look at the difference between the
debt issued and the debt repayment, the company
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borrowed more than $24 billion over those
five years to pay for all this.
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So this is something that obviously couldn’t
go on forever.
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The company’s sales weren’t rising fast
enough, interest payments were ballooning
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and the stock price tumbled from a high of
about $215 a share in early 2013 to $150 per
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share towards the end of 2017 when Buffett
finally gave up on the investment.
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This is something you have to watch, especially
in those dividend stocks with a high payout
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ratio.
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You need to check back each year into that
Statement of Cash Flows, look at how much
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cash the company is paying out in dividends
and share buybacks.
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Then look at where that money is coming from.
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Is it coming from cash generated by the business,
that Cash Flow from Continuing Operations,
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or is it coming from new debt?
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Is the company still spending as much as it
has in the past on capital expenditures, that
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money reinvested to keep the company competitive
and grow it, or is it cutting back in order
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to meet those cash payouts?
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Our third risk to remember when you’re looking
at the dividend payout ratio is you can’t
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apply this to real estate investment trusts,
REITs, or to master limited partnerships,
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MLPs.
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We talked about this in a prior video on these
two special types of companies.
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REITs hold and manage real estate and then
pay out the majority of cash flow to investors.
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MLPs hold energy assets like pipelines and
storage facilities.
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Both get a special tax break by paying out
most of the annual income as dividends so
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these are some of the best dividend yielding
stocks you can find with a yield three-times
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the market average.
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The problem is that these two types of companies
have so much in depreciation expense, that’s
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the accounting trick they get to use on the
income statement.
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They have these properties or pipelines and
get to take a certain amount off the value
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each year to deduct it from their earnings.
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That makes their earnings, that net income
look artificially low because the deduction
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isn’t actually cash going out the door.
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So if you take the dividend payment divided
by this artificially lower net income for
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these types of companies, you get a payout
ratio of over 100%, making it look like they’re
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paying out more than they have and in danger.
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I’m going to link to that prior video where
I explain this in more depth but with MLPs
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and REITs, you have special earnings measures
you use instead of that net income.
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For REITs, you use what’s called the funds
from operations or FFO.
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For MLPs, you use what’s called the distributable
cash flow or DCF.
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I’ll show you how to find both of these
next but they’re always available on a company’s
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annual report as well so you don’t necessarily
have to calculate them.
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Just like with using net income when we calculate
the dividend payout ratio, you use these two
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measures, the FFO for REITs and the DCF for
MLPs, to find how much of the company’s
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core earnings it’s paying out as dividends.
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You can then compare that to similar companies
and to the company’s own history to analyze
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if it’s maybe paying too much or could increase
the payout.
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Here’s the table to find the DCF for master
limited partnerships, and again don’t get
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freaked out because this is always provided
to you in reporting.
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To find how much money the company has available
to distribute, you take the cash flow from
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operations, this is all going to be found
on the Statement of Cash Flows, and you remove
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any spending on capital and income from non-controlling
interests.
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That gives you sustainable DCF which is what
the company can return to investors and still
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keep operations running smoothly.
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While sustainable DCF is a better measure,
most people use the DCF as reported because
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it’s sometimes the only number reported.
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To get to DCF, you also add back that income
from non-controlling interests as well as
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working capital reported.
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The big one here is adding back this proceeds
from asset sales.
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This is technically proceeds the company can
return to investors, a company can’t forever
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be selling its assets and still keep business
running so that’s why we use that sustainable
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DCF if it’s available.
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You see here the coverage ratio for a group
of MLPs and that the average is around a DCF
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that’s 1.2 times the distribution.
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This means the company has cash flow about
20% higher than what it’s returning but
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you also see some companies here that save
back more or much less.
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For real estate trusts, FFO is very similar
to that DCF we saw with MLPs.
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You take the reported net income of the REIT
and add back depreciation but minus out any
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gains they made on property sales.
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Those property sales are a source of income
but not something the REIT can do forever
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and expect to stay in business.
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Investors also look at the adjusted funds
from operations this AFFO, which takes out
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capital expenditures.
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Capex here is money the company spends to
keep its properties in good shape so maintenance
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spending.
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Remember, the idea is to find how much cash
the company has available to distribute without
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cutting into money it needs to run the business.
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I’ll link to that video in the description
below and click through because I spend more
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time walking through these two measures.
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REITs and MLPs are some of the best investments
you can make but you need to know how they
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differ from regular stocks.
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We’re about half way through out 2019 Dividend
Stock Challenge portfolio and the stocks are
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blowing up.
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The portfolio is up over 24% so far and beating
the market by nearly ten percent.
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I’ll leave a card here in the corner and
a link in the description as well to see how
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we picked dividend stocks for the portfolio
and how you can join the challenge.
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We’re here Mondays, Wednesdays and Fridays
with the best videos on beating debt, making
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more money and making your money work for
you.
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If you’ve got a question about money, just
subscribe to the channel and ask it in the
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comments and we’ll answer it in a video.
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