Evaluating Payout Ratios and Coverage: The Numbers That Predict Dividend Cuts

Payout ratio analysis—calculating what percentage of earnings a company pays as dividends—shows up in portfolio decisions as avoiding dividend cuts before they happen, identifying sustainable income sources, and distinguishing real yield from yield traps. Since 2015, investors using dividend safety scores with payout ratio analysis avoided 97% of dividend cuts (886 of 906 cuts, Simply Safe Dividends). The practical skill isn't memorizing formulas. It's recognizing when a dividend is living beyond its means—before your income disappears.

What Payout Ratio Actually Tells You (The Core Concept)

The payout ratio answers one question: How much of what the company earns goes to shareholders as dividends?

The calculation: Payout Ratio = (Dividends per Share / Earnings per Share) × 100

Example:

• Company pays $2.00 annual dividend per share
• Company earns $5.00 per share
• Payout ratio: $2.00 / $5.00 = 40%

This means 40% of earnings go to dividends, and 60% is retained for reinvestment, debt paydown, buybacks, or cushion against bad years.

The point is: A payout ratio is a sustainability signal. Low ratios suggest room for growth or buffer against earnings drops. High ratios suggest the dividend is stretching the company's capacity.

The 41% Threshold (What the Data Shows)

Historical analysis reveals that the safest dividend payout ratio has been around 41% (Hartford Funds / S&P Dow Jones Indices). Companies with highest payout ratios have a disproportionate number of dividend cuts since the Global Financial Crisis.

Why 41% works:

• Leaves 59% of earnings for business reinvestment
• Provides cushion if earnings drop 30-40%
• Signals management prioritizes long-term stability over short-term yield

Practical benchmarks:

The Walgreens example: At end of 2023, Walgreens had a 290.91% payout ratio—paying nearly 3x earnings in dividends. In January 2024, they cut the dividend and were removed from the Dividend Aristocrats. The math was impossible before anyone needed to speculate about strategy or competition.

Coverage Ratio (The Inverse Perspective)

Coverage ratio is payout ratio flipped—it shows how many times over the company can pay its dividend from earnings.

The calculation: Dividend Coverage Ratio = Earnings per Share / Dividends per Share

Example:

• Company earns $5.00 per share
• Company pays $2.00 dividend
• Coverage ratio: $5.00 / $2.00 = 2.5x

This means earnings cover the dividend 2.5 times. The company could absorb a 60% earnings decline before the dividend exceeds earnings.

Coverage benchmarks:

The durable lesson: Coverage ratio and payout ratio are two views of the same metric. A 50% payout ratio equals 2.0x coverage. Use whichever framing helps you think clearly—but check one or the other for every dividend stock.

Sector Adjustments (Why 60% Isn't Universal)

Different industries have different sustainable payout levels. Applying a blanket 60% threshold ignores business model differences.

Utilities (70-80% acceptable):

• Regulated revenue streams
• Predictable demand (everyone needs electricity)
• Limited reinvestment needs
• High ratios are normal and sustainable

Growth sectors (below 50% preferred):

• Need capital for R&D, expansion
• Earnings reinvestment drives future value
• High payout signals lack of growth opportunities

REITs (use FFO, not earnings):

• Required to distribute 90% of taxable income
• Net income is distorted by depreciation
• Use FFO (Funds From Operations) payout ratio instead
• FFO payout below 80% is safe, 35-60% ideal

Financials (40-60% typical):

• Regulated capital requirements
• Earnings can be lumpy
• Moderate ratios reflect regulatory constraints

The point is: Sector context matters. A utility at 75% payout isn't necessarily riskier than a tech company at 45%. But a utility at 95% and a tech company at 85% are both warning signs within their respective contexts.

How to Calculate Payout Ratio (Step-by-Step)

What you need:

• Annual dividend per share (found on any stock quote site)
• Earnings per share (from most recent annual report or TTM)

Step 1: Find annual dividend

• Quarterly dividend × 4 = annual dividend
• Or search "[stock ticker] annual dividend"

Step 2: Find EPS

• Use trailing twelve months (TTM) EPS for current picture
• Or forward EPS estimates for forward-looking view

Step 3: Calculate

• Divide dividend by EPS
• Multiply by 100 for percentage

Example with real numbers:

• Johnson & Johnson (JNJ): $4.96 dividend / $10.05 EPS = 49% payout ratio
• Coca-Cola (KO): $1.94 dividend / $2.69 EPS = 72% payout ratio

JNJ has more cushion. KO is higher but historically sustainable given their cash flow stability. Both require context, not just the number.

Warning Signs in Payout Ratio Trends (What to Watch)

A single payout ratio snapshot matters less than the trend over time. Watch for:

Rising payout ratio (earnings falling faster than dividends):

• 2020: 45%
• 2021: 52%
• 2022: 61%
• 2023: 73%

This trajectory signals trouble. Either earnings are declining or management is stubbornly maintaining dividends beyond capacity. Both are concerning.

Payout ratio exceeding 100%: When dividends exceed earnings, the company is funding dividends through:

• Cash reserves (temporary)
• Debt (dangerous)
• Asset sales (unsustainable)

None of these work long-term. A payout ratio above 100% for two consecutive years almost guarantees a cut.

The Intel example: Intel cut their quarterly dividend by 66% (from $0.365 to $0.125 per share) in February 2023. Warning signs preceded the cut: declining market share, heavy capex requirements, and a payout ratio that made no sense given capital needs.

Beyond Payout Ratio (Why FCF Matters More)

Earnings-based payout ratios have a weakness: earnings can be manipulated or disconnected from cash.

Companies can show positive earnings while:

• Burning cash on working capital
• Spending heavily on capex
• Using accounting adjustments

The better metric: Free Cash Flow (FCF) payout ratio

FCF Payout Ratio = Total Dividends Paid / Free Cash Flow

This measures whether the dividend is funded by actual cash the business generates, not accounting profits.

Example:

• Company pays $500 million in dividends
• Company generates $800 million in FCF
• FCF payout ratio: $500M / $800M = 62.5%

Why this matters more: Research combining dividend yield and FCF yield found that the top quintile portfolio outperformed the broader market by 6.03% annually (S&P Dow Jones Indices). FCF coverage is the most direct test of whether a dividend can actually be funded.

If earnings payout ratio is 50% but FCF payout ratio is 120%, the dividend is not covered by cash. The company is borrowing or depleting reserves. This is unsustainable regardless of what the earnings ratio suggests.

Detection Checklist (Before You Buy)

Before adding any dividend stock, verify these five items:

Essential checks (takes 5 minutes):

• Payout ratio below 60% (or sector-appropriate threshold)
• Payout ratio stable or declining over past 3 years
• Payout ratio never exceeded 80% in past decade (including recessions)

Deeper checks (takes 15 minutes):

• FCF payout ratio below 80%
• Coverage ratio above 1.5x on FCF basis

Red flags that override good ratios:

• Payout ratio spiked recently (earnings collapse)
• Company taking on debt while maintaining high payout
• Management discussing "capital preservation" or "balance sheet priorities"

The point is: You don't need to predict dividend cuts—you need to measure sustainability. The numbers tell you most of what you need to know.

Common Mistakes (And How to Avoid Them)

Mistake 1: Using payout ratio alone. A 40% payout ratio means nothing if FCF coverage is below 1.0x. Always verify with cash flow.

Mistake 2: Ignoring sector context. A utility at 75% is normal. A tech company at 75% is stressed. Know your sector norms.

Mistake 3: Looking at one year. A temporarily high payout ratio during a bad earnings year isn't automatically dangerous. Look at 3-5 year trends and ask: Is this an anomaly or a pattern?

Mistake 4: Trusting dividend history over current math. Walgreens was a Dividend Aristocrat with 47 years of increases. The 290% payout ratio mattered more than the streak.

Next Step (Put This Into Practice)

Action: Calculate payout ratios for your three largest dividend holdings.

How to do it:

1. Find each stock's annual dividend per share
2. Find trailing twelve-month EPS
3. Calculate: Dividend / EPS × 100

Interpretation:

• Below 50%: Well-covered, room for growth
• 50%-70%: Acceptable, monitor trends
• Above 70%: Investigate FCF coverage and recent earnings trajectory

If any position exceeds 70%: Pull up the FCF payout ratio. If FCF coverage is also stretched (above 80%), you've identified a position that deserves closer scrutiny—regardless of the company's dividend history.

Payout ratio analysis is defensive. It won't find you the next great dividend grower. But it will help you avoid holding stocks through 40-50% dividend cuts—and that's worth the five minutes per position.