A 7% Dividend May Look Tempting, But Check This Number Before Buying

A 7% dividend yield can look like an easy answer to a retirement income problem. But before focusing on how much a stock pays, investors should examine another number: the payout ratio.

The payout ratio shows how much of a company's earnings is distributed to shareholders. It can provide useful context about whether a dividend is supported by the company's financial performance.

A high yield does not automatically mean a dividend is unsafe. Investors still need to understand what is driving the yield and whether the company has sufficient earnings or cash flow to maintain its payments.

Why the Payout Ratio Matters

The payout ratio measures the proportion of a company's earnings that goes towards dividends. Consider a company that earns $5 per share and pays a $2 dividend. Its payout ratio is 40%. The company retains the remaining $3 per share for purposes such as reducing debt, investing in the business, making acquisitions or buying back shares. Now consider a company earning $5 per share while paying $5.50 in dividends. Its payout ratio would be 110%.

That does not automatically mean a dividend cut is coming. Some businesses have cash flows that are better reflected by measures other than reported earnings. However, a payout above 100% can raise questions about how the dividend is being funded. For retirement investors, those questions matter because replacing lost dividend income can be difficult.

The Right Measure Can Vary

Payout ratios should not be assessed in exactly the same way across every industry. Banks and insurers can often be assessed using earnings. Real estate investment trusts, or REITs, commonly use adjusted funds from operations, while some pipeline companies focus on distributable cash flow.

The principle is the same: investors should compare the dividend with the financial measure that best reflects the company's ability to generate sustainable cash. A low payout ratio is not automatically a reason to buy a stock either. Income investors may want a dividend that provides meaningful income while leaving the company enough resources to maintain and grow its operations.

What Manulife's Numbers Show

Manulife Financial provides an example of why the payout ratio can offer useful context. The insurer reported second-quarter core earnings of $1.9 billion, up 12% from the same period a year earlier. Core earnings per share increased 16% to $1.09. The quarterly dividend was $0.49 per share.

Using those figures, the quarterly core dividend payout ratio was approximately 44%. That was near the upper end of Manulife's medium-term target range of 35% to 45%. The company's core earnings therefore covered the dividend on this measure. Manulife's annualised dividend was $1.94 per share. At the supplied share price of $61.53, that represented a dividend yield of approximately 3.2%.

That is considerably below 7%. The comparison shows why investors should look beyond the headline yield and examine how much of a company's earnings is required to fund its dividend.

Manulife Is Still Exposed to Risk

Dividend coverage does not remove the other risks associated with owning an insurer. Manulife operates across insurance, retirement, and wealth management, with businesses in Canada, Asia, and the US. Its financial results can be affected by investment markets, interest rates, insurance claims, policyholder behaviour, and changes in assumptions about future liabilities.

The company has also taken steps to reduce exposure to its legacy US long-term-care business. In August, it announced a $3.2 billion reinsurance transaction covering part of that business. The transaction followed two earlier deals involving the same broader legacy portfolio.

Manulife said the three transactions together would reduce its legacy long-term-care reserves by about 24%. Those transactions may reduce a specific area of exposure, but they do not eliminate the broader risks associated with the insurance business.

What Investors Should Check

A 7% dividend requires more investigation than simply looking at the headline yield. Investors can examine what is driving the yield and whether the dividend is supported by earnings or cash generation. They should also consider debt, cash flow, earnings trends, balance-sheet strength, and the company's industry.

Manulife's figures demonstrate why these measures provide useful context. At the supplied share price, its dividend yield was about 3.2%, while its core dividend payout ratio was around 44%. Neither figure guarantees future returns or prevents a dividend reduction. However, the payout ratio can help investors understand how much of a company's earnings is being allocated to dividends. For someone planning retirement income, that information can be more revealing than the headline yield alone.