Dividends are one way companies share their profits with the investors who hold their common stock. But companies usually need to plow some of their profits back into the business, as well, if they hope to modernize their production operations, fund the kind of research and development effort that will guarantee a steady line of improved products, and make other improvements so necessary to the longer-term success of the business.

PASS THROUGH SECURITIES

Most of the securities we follow in The 25% Cash Machine are paying dividends with yields upward of 10%. These companies are structured as "pass through" securities, meaning they simply funnel most of the profits to the shareholders in the form of regular distributions. Therefore, the kinds of securities we are investing in -- purely by design -- will have abnormally high payout ratios.

A company's payout ratio is a measure of how much profit it is returning to shareholders in the form of dividends. Some companies strive mightily to increase their dividends on a regular basis, even when their earnings may actually decrease. That will cause their payout ratio to jump, if only temporarily.

PAYOUT RATIOS

Context is all-important here. As far as common stocks go, utility companies tend to have the fattest payout ratios (roughly 40%), providing investors with a dividend yield of somewhere between 3% and 4%. An investor is well advised to compare the payout ratio of a company with other companies in the same industry, in order to better understand if the ratio is out of line.

Different industries sport very different payout ratios.

Much depends on the type of security we're talking about. Canadian Trusts have payout ratios that average about 75%, which is normal for that kind of security. On the other hand, if General Motors had a 75% payout ratio, you'd be darn certain it couldn't maintain that level of dividend payment -- not unlike the recent 50% cut GM shareholders were just nailed with earlier this month.

Here's how some of our high-yield 25% Cash Machine sectors compare with traditional income sectors, in aggregate terms of payout ratios:

In the context of the dozen or so classes of securities in which we are investing, the payout ratios will run between 50% and 95%, because they are not your average blue chip stocks that retain most of the earned income for organic growth purposes. Our chosen Cash Machine stocks are designed to kick out the majority of what they earn and pay the higher pay-out ratios.

As you can see, these pay-out ratios vary quite a bit. Most of the security types listed above want to maintain consistent payouts, so as their earnings fluctuate, their payout ratios fluctuate accordingly. The numbers above are an average for each group, but there are also extreme cases in each.

If I were invested in a fixed asset like an iron ore grantor trust or a gas pipeline master partnership -- entities that are not growing the assets -- then I want a 100% payout ratio.

If I'm in a growing entity like a Business Development Company or shipping/tanker company, then I want these entities to show they can pay out a double-digit dividend and (most importantly) still have money left to reinvest in the business for future growth.

Look at it this way -- if we're going to get two to three times the dividend yield of common stocks then we would naturally expect the payout ratios to be much higher.

Ideally, we want to see our high-yield growth stocks pay out a double-digit yield and stay under an 80% payout ratio. When I research a high-yield investment, aside from those securities that are strictly designed to pay out 100% of net income, I want to see a payout ratio of no more than 80% on our other pass-through securities, because then I know there is at least 20% of net capital going back into the business to grow it.

So you can see how companies like the ones we follow (having payout ratios averaging 70% to 95%) can pay out double-digit dividend yields on businesses that are showing fundamental improvement (i.e., re-investing in themselves for the future).

As income investors, we are simply getting the lion's share of the earnings while accepting the fact that less of the profits will be available for expanding the existing business -- and this is a payout process that works for these companies.

Bryan

P.S. If you’d like to get in on high yield stocks with solid pay out ratios that give you the chance to earn returns between 25% to 50%, then join me at the 25% Cash Machine. You can get started with a no-risk trial subscription by clicking here.