Adjusted long term payout ratio

What Is Adjusted Long-Term Payout Ratio?

The Adjusted Long-Term Payout Ratio is a sophisticated financial ratio that measures the proportion of a company's sustainable earnings distributed to shareholders over an extended period, factoring in non-recurring items, non-cash expenses, and other capital allocation decisions like share buybacks. Unlike the basic dividend payout ratio, which primarily uses net income, the Adjusted Long-Term Payout Ratio provides a more accurate assessment of a company's capacity to maintain and grow its payouts by looking at a truer measure of free cash flow over multiple fiscal periods. This metric is a vital tool in corporate finance for evaluating dividend sustainability and a company's overall financial health.

History and Origin

The concept of evaluating a company's dividend payments against its earnings has existed for decades. The traditional dividend payout ratio, calculated as dividends divided by net income or earnings per share, served as an initial gauge. However, as financial reporting became more complex and companies adopted varied capital allocation strategies, the limitations of this basic ratio became apparent. For instance, companies in capital-intensive industries often have significant depreciation expenses that reduce reported net income but do not represent actual cash outflows, making their standard payout ratios appear artificially high. Similarly, the rise of share buybacks as an alternative method of returning value to shareholders meant that focusing solely on dividends could present an incomplete picture.

The need for "adjusted" payout metrics gained prominence as analysts and investors sought to better understand a company's long-term ability to distribute profits. Academic and financial research, like the "payout ratio method" discussed by O'Shaughnessy Asset Management, began exploring how different components of earnings (paid out vs. reinvested) contribute to total shareholder returns, emphasizing the need for a comprehensive view beyond simple reported figures.¹⁰ Over time, the informal practice of making these adjustments evolved into a more formalized approach, leading to metrics like the Adjusted Long-Term Payout Ratio, which seeks to normalize earnings and account for all forms of shareholder remuneration.

Key Takeaways

• The Adjusted Long-Term Payout Ratio provides a more accurate measure of a company's capacity to pay dividends by adjusting for non-cash items and other capital distributions.
• It considers a company's free cash flow generation over multiple periods, offering insight into the sustainability of payouts.
• The ratio helps investors gauge whether a company is overextending itself to maintain dividend payments or has ample room for future increases.
• An Adjusted Long-Term Payout Ratio is particularly useful for analyzing companies in industries with significant non-cash expenses or those that frequently engage in share buybacks.
• It serves as a critical component in developing a robust investment strategy focused on income generation and long-term shareholder value.

Formula and Calculation

The Adjusted Long-Term Payout Ratio does not have a single, universally standardized formula, as the "adjustments" can vary based on the analyst's or investor's specific focus. However, a common approach involves modifying the numerator (dividends) and/or the denominator (earnings) to reflect a more sustainable measure of distributable profit over a multi-year period.

A generalized formula might look like this:

Where:

• Total Dividends Paid (over N years): The cumulative amount of cash dividends distributed to common shareholders over a specified long-term period (e.g., 3, 5, or 10 years). Dividends paid to preferred stock holders are typically excluded.
• Total Share Buybacks (over N years): The cumulative value of shares repurchased by the company over the same N-year period. This inclusion recognizes buybacks as another way companies return value to shareholders.
• Total Adjusted Earnings/Free Cash Flow (over N years): The cumulative measure of a company's earnings or cash flow, adjusted for non-recurring items and non-cash charges (like depreciation and amortization) and often accounting for maintenance capital expenditures to derive a true free cash flow available for distribution. This is often an average of cash flow from operations less maintenance capital expenditures over the period.

For industries like Real Estate Investment Trusts (REITs) or Master Limited Partnerships (MLPs), which have high non-cash depreciation expenses, an adjustment often involves using metrics like Adjusted Funds From Operations (AFFO) instead of reported net income in the denominator to get a clearer picture of distributable cash flow.⁹

Interpreting the Adjusted Long-Term Payout Ratio

Interpreting the Adjusted Long-Term Payout Ratio requires context and a nuanced understanding of a company's business model and industry. A lower Adjusted Long-Term Payout Ratio generally suggests a greater margin of safety for dividend payments and more retained earnings available for reinvestment or growth initiatives. Conversely, a very high ratio, especially one consistently above 100%, could indicate that a company is distributing more cash than it sustainably generates, which may lead to future dividend cuts or an unsustainable reliance on debt to fund payouts.⁸

For mature companies in stable industries, a higher Adjusted Long-Term Payout Ratio might be acceptable, as they may have fewer high-return reinvestment opportunities and thus return more cash to shareholders. However, for growth-oriented companies, a lower ratio is often preferred, as it signifies a commitment to reinvesting profits back into the business to fuel expansion. Investors should compare a company's Adjusted Long-Term Payout Ratio to its historical levels and to that of its industry peers to assess its sustainability and alignment with its overall investment strategy.

Hypothetical Example

Consider "Evergreen Utilities Inc.," a well-established utility company known for its consistent dividends. An investor wants to analyze its Adjusted Long-Term Payout Ratio over the past five years to assess dividend sustainability.

Here's the hypothetical data for Evergreen Utilities Inc. over five years:

Step 1: Calculate Total Distributions over 5 years
Total Dividends Paid = 100 + 105 + 110 + 115 + 120 = 550 million USD
Total Share Buybacks = 10 + 12 + 15 + 18 + 20 = 75 million USD
Total Distributions = 550 + 75 = 625 million USD

Step 2: Calculate Total Adjusted Free Cash Flow over 5 years
Total Adjusted Free Cash Flow = 150 + 160 + 170 + 180 + 190 = 850 million USD

Step 3: Calculate the Adjusted Long-Term Payout Ratio

This 73.5% Adjusted Long-Term Payout Ratio suggests that Evergreen Utilities Inc. has, on average over the last five years, distributed about 73.5% of its adjusted free cash flow to shareholders through dividends and buybacks. This ratio, while higher than some industries, might be considered sustainable for a mature utility company with stable cash flow and limited significant growth opportunities, allowing it to return a substantial portion of its earnings.

Practical Applications

The Adjusted Long-Term Payout Ratio finds several practical applications in investment analysis and corporate finance:

• Dividend Sustainability Assessment: For income-focused investors, this ratio is crucial for determining if a company's dividend payments are truly sustainable over the long term. By accounting for non-cash expenses and capital allocation choices, it offers a more realistic view than simpler metrics. A consistently high ratio could be a warning sign, as it indicates a limited buffer against economic downturns or unexpected expenses.⁷
• Valuation Models: In dividend discount models or other valuation approaches that rely on projected dividend growth, understanding a company's historical and expected Adjusted Long-Term Payout Ratio helps in forecasting future dividend capacity and growth rates.
• Cross-Industry Comparisons: The adjusted nature of the ratio makes it more reliable for comparing companies across different industries, especially those with varying accounting practices for non-cash items or different capital structures. For example, comparing a Real Estate Investment Trust (REIT) to a technology company using only net income-based payout ratios would be misleading due to differing depreciation impacts on reported earnings.⁶
• Management Policy Evaluation: Analysts use the Adjusted Long-Term Payout Ratio to evaluate how effectively management balances returning capital to shareholders with reinvesting in the business for future growth. A company with a very low ratio might be hoarding cash, while one with an overly high ratio might be sacrificing future growth.
• Mergers and Acquisitions (M&A): During due diligence for M&A, understanding the Adjusted Long-Term Payout Ratio of a target company helps in assessing its long-term cash generation and distribution capabilities, which influences valuation and integration strategies.

Limitations and Criticisms

Despite its advantages, the Adjusted Long-Term Payout Ratio is not without limitations:

• Lack of Standardization: The primary criticism is the absence of a universally accepted formula for "adjustment." Different analysts and firms may include or exclude various items (e.g., non-recurring gains/losses, specific types of capital expenditures, certain non-cash charges), leading to inconsistencies and making direct comparisons between analyses challenging.
• Complexity: The calculation can be more complex than the simple dividend payout ratio, requiring a deeper dive into financial statements to identify and quantify the necessary adjustments. This complexity can also introduce a degree of subjectivity.
• Historical Data Dependence: As a "long-term" ratio, it relies on historical data, which may not always be indicative of future performance. Significant changes in a company's business model, industry landscape, or economic conditions can render past trends less relevant.
• Ignores Debt and Liquidity: While it focuses on distributable earnings, it doesn't directly assess a company's overall debt burden or its immediate cash flow and liquidity position. A company with a healthy Adjusted Long-Term Payout Ratio might still face short-term liquidity issues or have excessive leverage. The traditional payout ratio, while imperfect, at least indirectly considers the impact of earnings volatility on a company's ability to fund growth, which can be masked by certain adjustments.⁵
• Short-Term Volatility: While designed to smooth out short-term fluctuations by using a multi-year average, a sudden, significant change in a company's earnings power or dividend policy in a single year might be obscured by the long-term average.

Adjusted Long-Term Payout Ratio vs. Dividend Payout Ratio

The Adjusted Long-Term Payout Ratio and the Dividend Payout Ratio both assess a company's dividend-paying capacity, but they differ significantly in their scope and methodology.

While the traditional dividend payout ratio offers a quick and simple insight, the Adjusted Long-Term Payout Ratio aims to provide a more comprehensive and accurate picture of a company's true capacity to return capital to its owners by smoothing out anomalies and incorporating a broader view of shareholder remuneration.

FAQs

Why is an "adjusted" payout ratio necessary?

An "adjusted" payout ratio is necessary because the standard dividend payout ratio, which relies on net income, can be misleading. Net income includes non-cash expenses like depreciation and may be affected by one-time events, which do not reflect the actual cash available for dividends. Adjustments provide a clearer view of sustainable distributable cash flow and account for other forms of shareholder return like share buybacks.

What constitutes "long-term" in this ratio?

"Long-term" typically refers to an average over several fiscal periods, commonly three, five, or even ten years. Using a multi-year average helps to smooth out year-to-year volatility in earnings and cash flow, providing a more stable and representative view of a company's ongoing payout capacity.

Is a high Adjusted Long-Term Payout Ratio always a bad sign?

Not necessarily. While a very high Adjusted Long-Term Payout Ratio (e.g., consistently above 90-100%) can signal unsustainability, the ideal ratio depends heavily on the company's industry and stage of maturity. Mature companies in stable sectors (like utilities) often have higher ratios because they have fewer high-growth capital expenditures and thus return more cash to shareholders. For growth companies, a lower ratio is generally preferred as they reinvest profits to fuel expansion.