Understanding the Dividend Payout Ratio: What Should It Be?

On rare occasions a company may offer a dividend payout ratio of more than 100. This tactic is often undertaken when attempting to inflate stock prices in the short term. Understanding what this ratio means and how to interpret it is crucial for investors.

What is the Dividend Payout Ratio?

The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company. It is the percentage of earnings paid to shareholders via dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or to reininvest in core operations. It is sometimes simply referred to as simply the payout ratio.

Interpreting the Dividend Payout Ratio

1. Maturity of the Company

Several considerations go into interpreting the dividend payout ratio, most importantly the company's level of maturity. A new, growth-oriented company that aims to expand, develop new products, and move into new markets would be expected to reinvest most or all of its earnings and could be forgiven for having a low or even zero payout ratio. On the other hand, an older, established company that returns a pittance to shareholders would test investors' patience and could tempt activists to intervene.

2. Dividend Sustainability

The payout ratio is also useful for assessing a dividend's sustainability. Companies are extremely reluctant to cut dividends since it can drive the stock price down and reflect poorly on management's abilities. If a company's payout ratio is over 100, it is returning more money to shareholders than it is earning and will probably be forced to lower the dividend or stop paying it altogether. However, this result is not inevitable.

A company experiencing a bad year without suspending payouts may still be in their interests to do so. It is, therefore, essential to consider future earnings expectations and calculate a forward-looking payout ratio to contextualize the backward-looking one. Long-term trends in the payout ratio also matter. A steadily rising ratio could indicate a healthy maturing business, but a spiking one could mean the dividend is heading into unsustainable territory.

Retention Ratio and Industry Considerations

The retention ratio is a converse concept to the dividend payout ratio. While the dividend payout ratio evaluates the percentage of profits earned that a company pays out to its shareholders, the retention ratio represents the percentage of profits earned that are retained by or reinvested in the company.

Dividend payouts vary widely by industry. For instance, real estate investment partnerships (REITs) are legally obligated to distribute at least 90% of earnings to shareholders due to special tax exemptions. Master Limited Partnerships (MLPs) also tend to have high payout ratios.

Augmented Payout Ratio

Dividends are not the only way companies can return value to shareholders. The augmented payout ratio incorporates share buybacks into the metric, calculated by dividing the sum of dividends and buybacks by net income for the same period. If the result is too high, it can indicate an emphasis on short-term boosts to share prices at the expense of reinvestment and long-term growth.

Another adjustment that can be made to provide a more accurate picture is to subtract preferred stocks' dividends for companies that issue preferred shares.

How to Calculate the Payout Ratio

To calculate the dividend payout ratio in Excel:

First, if you are given the sum of the dividends over a certain period and the outstanding shares, you can calculate the dividends per share (DPS). Suppose a company paid a total of 5 million in dividends last year and has 5 million shares outstanding. In Excel, enter the formula to calculate DPS. Next, calculate the earnings per share (EPS) if it is not given. In Excel, enter the formula to calculate EPS. Finally, calculate the payout ratio. In Excel, enter the formula to calculate the payout ratio.

Example of How to Use the Payout Ratio

Companies that make a profit at the end of a fiscal period can do several things with the profit they earned. They can pay it to shareholders as dividends, retain it to reinvest in the growth of its business, or do both. The portion of the profit that a company chooses to pay out to its shareholders can be measured with the payout ratio.

Dividend Payout vs. Dividend Yield

It is important to know the difference between the dividend yield and the dividend payout ratio. The dividend yield tells you what the simple rate of return is in the form of cash dividends to shareholders, whereas the dividend payout ratio represents how much of a company's net earnings are paid out as dividends.

While the dividend yield is the more commonly known and scrutinized term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company's cash flow.

In summary, understanding the dividend payout ratio and its implications can help investors make informed decisions about a company's financial health and its ability to sustain dividends in the long term.