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326 firms with negative earnings paid dividends

150 firms paid out more in dividends than they earned

Negative 0.01-10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80%

Payout Ratio

Data from Value Line: The payout ratio is the dollar dividend paid out as a percent of the net income. If the net income is negative, the payout ratio cannot be calculated.

A firm that has a dividend payout ratio greater than 100% paid out more than its earnings as dividends at least in the most recent financial year. If its earnings do not recover promptly, this is clearly unsustainable for the long term and can have significant accounting and economic consequences. From an accounting standpoint, this action will reduce the book value of equity in the firm. From an economic standpoint, the firm is not only not reinvesting back into the business but is reducing its asset base, thus reducing its capacity to grow in the future.

While avoiding firms that pay out more than what they are earning as dividends may be an obvious strategy, you could impose tighter constraints. For instance, some conservative investors and financial advisors suggest that you avoid firms that pay out more than a certain percent of their earnings - two thirds (or a payout ratio of 67%) is a commonly used rule of thumb. While these constraints are usually arbitrary, they reflect the fact that earnings are volatile and that dividends in firms that pay out more than the cut-off payout ratio are at risk.

Revisit the sample of the 100 companies with the highest dividend yields (from Table 2.3) and compare annual dividends to trailing earnings - earnings in the most recent four quarters. Figure 2.8 summarizes the findings:

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