In this article, we cover how to calculate the dividend payout ratio. The Dividend payout ratio is one of the most important investor ratios. It provides an indicator of potential income for the investor with a stock. Investors looking for a regular income are particularly interested in the dividend payout ratio.
Table of contents
- What is Dividend Payout Ratio?
- How to Calculate Dividend Payout Ratio?
- Dividend Payout Ratio and the Retention Ratio
- Dividend Payout Ratio and Dividend Yield
- What Is A Good Dividend Payout Ratio?
- Dividend Payout Consistency and Stability
- Dividend Payout Ratio Comparisons
- Why does Dividend Payout Ratio Matter?
- Limitations of Dividend Payout Ratio:
- Conclusion
What is Dividend Payout Ratio?
Dividend payout ratio is the measure of cash dividends paid out to the shareholders in percentage terms. It can be calculated in total dividend and earnings term or on a dividend and income per share basis. It is the amount a company distributes back to the shareholders.
How to Calculate Dividend Payout Ratio?
The dividend payout ratio, or simply called payout ratio can be calculated in two ways.
Dividend Payout Ratio = (Total dividend paid in cash/Total net income) × 100
Dividend Payout Ratio = (Dividend per share/Earnings per share) × 100
As the dividend payout ratio is closely observed in conjunction with Retention ratio, it can be calculated from the retention ratio as well:
Dividend Payout Ratio = 1 – Retention ratio
Simply, the total net income of a business will either be retained or distributed to the shareholders as dividends.
Dividend Payout Ratio and the Retention Ratio
The Retention ratio indicates the portion of net income invested back to the business in percentage terms. As the net income is distributed between the retention as retained earnings and the dividend for shareholders, both the ratios are directly linked.
For example, if a business has a dividend ratio of 60% out of its net income, it would imply that the retention ratio is 40%. Both the ratios can be calculated with a direct correlation through a simple equation:
Dividend Payout Ratio = 1 – Retention ratio
From the outset, both ratios indicate the utilization of net income by a business. Investors will be keener to see a higher dividend payout ratio, while the management may look to retain incomes for expansion and investment back to the business projects.
Dividend Payout Ratio and Dividend Yield
The Dividend yield is the indicator of an investor’s return per share in dividend terms. It indicates how much a company pays in a dividend to its shareholders in percentage terms. The payout ratio indicates the portion of net income distributed to the shareholders i.e. ability of a company to payout the dividend. The Dividend yield indicates the gains made on investment by the shareholders.
The Dividend payout ratio is a better indicator of a company’s financial health and net income. The company may also issue a dividend in non-cash form or by borrowing money from the market. For a clear interpretation of a company’s net income, the dividend payout ratio out of net income provides a better measure.
What Is A Good Dividend Payout Ratio?
As it is common with any ratio analysis, the dividend payout ratio cannot be interpreted alone. A large company paying large sums of net income to the shareholders may still be paying less portion of income than a small company in the same industry.
For example, a large firm A with an EPS of $5.60 pays out a dividend of $ 0.90 per share. Another company B with an EPS of $ 4.30 pays out a dividend of $ 0.90 per share.
Dividend Payout ratio of A = 0.90/5.60 × 100 = 16.07%
Dividend Payout ratio of B = 0.90/4.30 × 100 = 20.09%
Apparently, both companies paid out the same amount of dividend per share, but company B paid a larger portion of net income to the shareholders than company A.
Similarly, if we consider the payout ratio for only one year, it may not reveal the true picture.
Dividend Payout Consistency and Stability
Investors will be keen on a consistent and stable dividend paying company rather than a one-time large dividend pay-off. A company’s ability to pay dividend on a consistent basis also indicates its good performance and generating enough profits to retain the ratio. A company may offer a one-time large dividend to its shareholders but it can be financed with debt and occasional profits.
Maintaining a consistent and stable payout ratio would require a company to continuously invest in positive cash flow projects. Lowering the payout ratio may affect the share prices as failing to meet shareholders’ expectations may have a signaling effect on stock prices. From the investors’ point of view, a low but consistent payout ratio will be preferred over a high and inconsistent payout ratio.
Dividend Payout Ratio Comparisons
Ratios cannot be interpreted without useful comparisons. Each industry sets its benchmarks for performance evaluations. A tech-based company such as Google cannot be compared with a retail firm like Walmart. Both industries have their benchmark standards for each performance indicator. It is suitable to compare payout ratios in the same industry, preferably for the same company size.
Why does Dividend Payout Ratio Matter?
The dividend payout ratio analysis offers two valuable insights, the amount paid back to the shareholders and the net income. Further elaboration reveals the split between dividend amounts and the retained earnings. For investors, it reveals the clearer picture of the earning potential of a company. If the company is not investing in positive cash flow projects, or the earnings are not sustainable, it cannot maintain a payout ratio.
A one-off analysis of the payout ratio may not portray the financial strength of a company. A historical comparison of a company’s payout ratio will provide a useful indicator of the company’s dividend paying ability. The payout ratio is not an earnings indicator for shareholders; rather it offers the financial strength analysis of a company.
It also offers insights into the management policy, as to how best the management can manage the cash surplus. A too higher than normal payout ratio may also indicate the failure of management to invest in any positive cash flow projects. Signaling effects in stock markets also play a crucial role in stock price determination. If a company’s payout ratio falls significantly it may reveal large losses for the fiscal year.
Investors are often indifferent when it comes to earnings with dividends or capital gains. A high payout ratio would lure in the investors looking for regular income. A lower payout ratio means the company retains large profits and invests in future projects. That realizes the capital appreciation of share prices in the long term. Thus, a standalone payout ratio cannot be interpreted as a good or bad ratio.
Limitations of Dividend Payout Ratio:
As with any ratio analysis, the dividend payout ratio also offers some limitations.
- A standalone payout ratio may not reveal the true financial strength of the company
- A high payout ratio means the company has not enough investment projects
- A lower payout ratio implies the company has not generated enough cash to pay back its shareholders
- Without historical or industry standard comparisons, the payout ratio cannot determine the true performance measurement indication
Conclusion
The Dividend payout ratio provides useful information than dividend yield. It can be used to interpret the earning potential of a company, the retention and dividend at the same time. It can also offer a good comparison to investors to compare the dividends in the same industry. However, a historical performance measure for the payout ratio trend can reveal better information on the company’s dividend paying ability.
