What Is a Dividend Payout Ratio?
The dividend payout ratio is the ratio of the entire amount of dividends paid out to shareholders in comparison to the net income of the company. This ratio is referred to as the dividend payout percentage. It is the proportion of a company’s profits that are distributed as dividends to shareholders. The portion of profits that is not distributed to shareholders is kept by the company and used to reduce or eliminate debt or to reinvest in the business’s core activities. The payout ratio is another name for it, however occasionally people just call it that.
Dividend Payout Ratio Formula and Calculation
The dividend payout ratio is calculated by dividing the yearly dividend per share by the earnings per share (EPS), or by dividing dividends by net income (as shown below).
The dividend payout ratio can also be calculated as follows:
Dividend Payout Ratio=1−Retention Ratio
On a per-share basis, the retention ratio can be expressed as:
What the Dividend Payout Ratio Indicates
The dividend payout ratio is interpreted using several factors, the most important of which is the company’s maturity level. A new, growth-oriented company that intends to expand, develop new products, and enter new markets is expected to reinvest the majority or all of its earnings and may be forgiven for having a low or even zero payout ratio. Companies that do not pay dividends have a payout ratio of 0%, while companies that pay out their entire net income as dividends have a payout ratio of 100%.
An older, established company, on the other hand, that returns a pittance to shareholders would put investors to the test and could entice activists to intervene. Apple (AAPL) began paying a dividend in 2012, nearly twenty years after the company had not paid one. The new CEO felt that the company’s enormous cash flow made a 0% payout ratio difficult to justify.
A high payout ratio indicates that a company has progressed beyond its initial growth stage, implying that share prices are unlikely to rise rapidly.
Dividend Sustainability
The payout ratio can also be used to determine the long-term survivability of a dividend. Companies are extremely hesitant to reduce dividends because it can lower stock prices and reflect poorly on management’s abilities. If a company’s payout ratio exceeds 100%, it is returning more money to shareholders than it is earning and will most likely be forced to reduce or eliminate dividend payments. That outcome, however, is not unavoidable.
It is often in a company’s best interests to endure a bad year without suspending payouts. To contextualise the backward-looking payout ratio, consider future earnings expectations and calculate a forward-looking payout ratio.
The payout ratio’s long-term trends are also important. A steadily rising ratio may indicate a healthy, maturing business, whereas a spiking one may indicate that the dividend is approaching unsustainable levels.
The dividend payout ratio is the inverse concept of the retention ratio. The dividend payout ratio assesses the percentage of profits earned that a company pays out to its shareholders, whereas the retention ratio assesses the percentage of profits earned that the company retains or reinvested.
Dividends Vary by Industry
There is a significant amount of variation in dividend payouts based on industry, and similar to most ratios, they are best relevant when compared within the same industry. For instance, although real estate investment partnerships (also known as REITs) are eligible for a number of advantageous tax breaks, the law requires them to hand up at least 90 percent of their profits to their shareholders.
Furthermore, payout ratios for master limited partnerships (MLPs) are typically rather high.
As a result of the fact that dividends are not the only way in which corporations can distribute value to shareholders, the payout ratio does not always provide an accurate picture of the situation. The enhanced payout ratio is a measure that takes into account share buybacks; it is derived by dividing the total amount paid out in dividends and buybacks by the amount of net income generated during the same time period. If the result is excessively high, it may suggest that the company places a greater priority on short-term increases in share prices at the expense of investing and long-term growth.
Another modification that may be done to create a more accurate image is to deduct dividends on preferred stock for corporations that issue preferred shares. This will provide a more true representation of the situation.
How to Use Excel to Figure Out the Payout Ratio
First, if you have the total dividends paid over a given period and the number of outstanding shares, you can calculate the dividends per share (DPS). Assume you have a stake in a company that paid a total of $5 million in dividends last year and has 5 million shares outstanding. Enter “Dividends per Share” into cell A1 of Microsoft Excel. Next, in cell B1, enter “=5000000/5000000”; the dividend per share in this company is $1.
The earnings per share (EPS) must then be calculated if it is not provided. In cell A2, type “Earnings per Share.” Assume the company earned $50 million in net profit last year. Earnings per share are calculated as (net income – dividends on preferred stock) (shares outstanding). In cell B2, type “=(50000000 – 5000000)/5000000.” This company’s EPS is $9.
Finally, determine the payout ratio: In cell A3, type “Payout Ratio.” Then, in cell B3, enter “=B1/B2”; the payout ratio is 11.11%. The ratio is used by investors to determine whether dividends are appropriate and sustainable. The payout ratio varies by industry; for example, startups may have a low payout ratio because they are more focused on reinvesting their earnings to grow the business.
Dividend Payout vs. Dividend Yield
When comparing these two metrics, it is essential to keep in mind that the dividend yield provides information regarding the straightforward rate of return in the form of cash dividends to shareholders, whereas the dividend payout ratio indicates the proportion of a company’s net earnings that are distributed in the form of dividends.
Many people believe that the dividend payout ratio is a more accurate measure of whether or not a firm will be able to maintain its current level of dividend payments into the foreseeable future, despite the fact that the dividend yield is the more widely used and examined word. The cash flow of a corporation is intimately tied to the dividend payout ratio of a company.
The dividend yield is an indication of how much of its stock price a firm has distributed to shareholders in the form of dividends over the course of a year. The yield is expressed as a percentage rather than a specific dollar figure in this example. This makes it much simpler to understand the proportion of a shareholder’s original investment that is returned to them in the form of dividends.
The yield is calculated as:
A dividend yield of 10% would be achieved by a corporation, for instance, if it maintained a stock price of $100 per share while paying out an annual dividend of $10 per share. You can also see that the dividend yield % drops when the share price goes up, and you can observe the opposite effect when the share price goes down.