What Is a Dividend Payout Ratio?

A dividend payout ratio, also sometimes referred to as simply the payout ratio, is a financial metric expressing the percentage of total dividends paid out by a company to its shareholders relative to their net income.

Why Is the Dividend Payout Ratio Important?

The dividend payout ratio is a financial metric indicating the percentage of cash paid out to a company's shareholders. It is a valuable financial metric to consider while evaluating how the company operates and whether it has any growth potential. When a company is paying dividends to its shareholders, the amount of cash available to reinvest into its daily operations becomes limited, making the dividend payout ratio a vital metric when analyzing a company.

How to Interpret the Dividend Payout Ratio

While it is never wise to make an investment decision based solely on a single financial metric, the dividend payout ratio can say a lot about a company and how it might align with your individual investment goals.

A company's dividend payout ratio can help indicate how safe the dividend payment is and whether there is room for management to grow the dividend in the future. Suppose a company finds itself short on cash to pay the bills or take advantage of a growth opportunity. The company would need to utilize available cash on hand, requiring them to slash its dividend (less money is available for shareholders) or raise additional capital through financing or issuing additional equity. Dividend cuts could cause significant upset with shareholders, causing them to run for the exit and tank the stock's market value. On the other hand, issuing equity has the potential for share dilution, which could significantly reduce the value of existing shares for investors, causing an upset. If the company decides to raise debt instead, future dividend growth could be affected due to new debt obligations.

High Dividend Payout Ratio

A high dividend payout ratio indicates the company has less money to reinvest back into the business. Companies that pay a large percentage of their profits to shareholders may do so for many different reasons. For instance, the company may not have a better use for the cash, so they have decided to reward investors instead of holding onto the money.

Another potential reason a company may have a high payout ratio is that it is in financial trouble and wishes to attract new investment capital to stay alive. High dividend yields often attract income investors looking for a stable source of passive income. An extremely high dividend payout should throw a red flag to the potential investor and indicate further due diligence is required to determine whether the company can sustain such a payout ratio.

A high dividend payout ratio could imply that the company has matured past its initial growth stage and can sustain its dividend payouts while maintaining daily operations. Some investors prefer companies at this stage and consider them to have proven their business model and financial strength.

Low Dividend Payout Ratio

Low dividend payouts indicate that a company has more money to reinvest in the business and further grow its operations. The theory is that because the company has more cash, it can more easily take advantage of business opportunities to increase earnings, leading to a potential rise in the stock's price. Growth investors tend to be attracted to these companies as they are less interested in dividend income and prefer capital gains.

What Is an Ideal Dividend Payout Ratio?

So, what is an ideal dividend payout ratio then? As with many things in investing, it, of course, depends. When analyzing dividend payout ratios, it's important to remember that payout ratios vary across stock sectors in the market.

Companies in the technology sector tend to reinvest in growth opportunities to remain relevant and generally pay less of their earnings as dividends. As a whole, the technology sector tends to have a low dividend payout ratio.

In contrast to the technology sector, more defensive sectors such as utilities, healthcare, and consumer staples maintain higher dividend payout ratios. Due to the nature of these companies, they tend to possess more stable earnings that are less affected by economic conditions and can afford to maintain a higher dividend payout ratio.

Dividend payout ratios change over time and are driven mainly by the stability of the company's business model and reinvestment needs. Some stocks, such as REITs (Real Estate Investment Trusts), must pay out 90% of earnings to shareholders by law.

As you can see, throwing out a blanket number as an ideal dividend payout ratio doesn't work to determine whether a stock is a good investment. An ideal payout ratio depends on many factors, such as the company's sector, maturity, business model, and tax status. Your personal investing goals should also be kept in mind.

What if a Dividend Payout Ratio Is Above 100%?

Simply put, a payout ratio above 100% indicates the company is paying out more money to shareholders than they are earning. A ratio above 100% may indicate the dividend is in jeopardy. Typically a payout this high shows poor financial health. It could mean a dividend cut is imminent in the foreseeable future. Nobody can pay out more than they earn indefinitely.

How to Calculate the Dividend Payout Ratio

There are a few ways to calculate how to calculate the dividend payout ratio. The dividend payout ratio is a snapshot of the dividends paid to shareholders relative to the company's net income.

While there are multiple ways to calculate a company's dividend payout ratio, one of the most straightforward formulas is simply taking their dividends per share (DPS) and dividing it by their earnings per share (EPS).

Dividend Payout Ratio = Dividends Per Share / Earnings Per Share

You can usually find EPS at the bottom of a company's income statement. Sometimes DPS is also found in the financial statements section of a 10-K or 10-Q. You may also find it by looking at the company's dividend announcement. However, you can easily calculate it yourself by taking the dividends off the balance sheet or the cash flow statement and dividing them by the total number of common shares.

Dividend Payout Ratio vs. Retention Ratio

The retention and dividend payout ratios are essentially two sides of the same coin and provide different perspectives for analysis. The retention ratio is simply the opposite of the payout ratio. Once you have calculated the dividend payout ratio, you can find the retention ratio by subtracting the dividend payout ratio from one. By finding one ratio, you have essentially found the other.

Dividend investors, also sometimes referred to as income investors, typically look at the dividend payout ratio when analyzing a company's financial strength. In contrast, growth investors are more interested in a company's ability to expand, thus are more likely to look at the retention ratio.

For example, if a company earns $100 million in net income and pays out a total of $64 million in dividends, the dividend payout ratio is 64% (calculated as $64 million / $100 million). To find the retention ratio, subtract the 64% dividend ratio from 1 (1 - 0.64), and you will get 0.36 or a 36% retention ratio.

Summary

The dividend payout ratio is a financial metric displayed as a percentage that indicates how much cash was paid to common shareholders as dividends relative to company earnings during a period. The dividend payout ratio can easily be calculated by dividing dividends per share (DPS) by earnings per share (EPS).

Dividend growth investors use the payout ratio to understand a company's ability to sustain or grow its dividend payments over time. In contrast, income investors may use the retention ratio derived (derived from the payout ratio) to determine a company's ability to expand its business operations.

It is impractical to give a blanket number as an ideal dividend payout ratio. Many variables such as age, sector, industry, competition, business model, and even laws influence a company's decision to pay a dividend. However, payout ratios above 100% should throw up warning flags to investors. It is crucial to remember payout ratios are only historical snapshots and change over time. It is helpful to compare dividend payout ratios against other companies in the same sector and industry, ideally with similar business models.