Dividend Payout Ratio
This is an advanced guide on how to calculate Dividend Payout ratio with thorough interpretation, analysis, and example. You will learn how to use its formula to assess a company's ability to pay dividends to its shareholders.
Definition - What is Dividend Payout Ratio?
The dividend payout ratio is a very useful calculation for the potential investor because it indicates how much of a company’s earnings are being paid out in the form of dividends.
But beyond the important question of how much you can regularly expect to receive as a cash payout, quite a lot of additional information can be gleaned about a company from the result of this ratio.
Because it’s extremely detrimental to any business to cut or eliminate the payment of a dividend once one’s been established, companies strive to generate enough income to consistently support and increase their dividend payments.
If a business isn’t generating sufficient earnings, it will have to supplement investor payouts from its cash reserves, and this is simply not a sustainable practice over the long run.
Alternatively, if you discover that an organization is only paying out a small portion of its overall income to investors, then you know that a significant amount of its earnings are being reinvested back into its own growth and expansion.
In this case, investors trade off some of their short-term dividend gains for the expected benefit of seeing their shares increase in price.
To find a company’s dividend payout ratio at the individual share level, you would use the following formula:
Payout Ratio = Dividend per Share / Earnings per Share
There is another, more broad-scope formula that is often used to arrive at the same conclusion, and it looks like this:
Payout Ratio = Total Dividend Paid / Net Income
While both versions of this formula will essentially give you the same result, the first version is often the simplest to use, since the figures it requires are generally published and made public on a regular basis.
Dividend Payout Calculator
So now you know the formula, let's have a look at the following example to learn how to calculate this ratio in real life.
You’re considering investing in Company MM that currently has 200,000 million shares outstanding, and would like to examine its most recent dividend payout ratio per share.
Assume that this company has reported a dividend per share of $1.00 and an earnings per share (EPS) of $2.00.
Using these figures and the formula given above, you can easily calculate the payout ratio of this company, as follows:
The ratio of 50% or 0.5 shows that this company has distributed 50% of its net income to its shareholders in the form of dividends.
Interpretation & Analysis
When the result of this ratio is greater than 1, it tells you that a business is paying out more in dividends than it’s actually generating in earnings.
This is not a sustainable practice, since it means that the company in question will be forced to use up cash reserves, sell off assets, or resort to debt in order to fund its ongoing shareholder obligations.
So what is a good dividend payout ratio?
Ideally, you should look for those firms with a dividend payout ratio of less than 0.6 or 60%.
When a business pays out 60% or less of its net income to investors, it means it will have 40% or more of its earnings left over to fund its own growth and expansion.
It also means the company will have a safety buffer in place, giving it the funds to continue to meet its dividend payments in the event that it experiences any short-term financial difficulties.
What is considered a high dividend payout ratio?
You should be cautious when investing in companies with a payout ratio of over 60%. However, this also varies from industry to industry.
A company that pays out too much dividends to its shareholders may face some financial difficulties as it does not have enough capital for expanding its core business.
In such cases, the company may have to borrow more money and that will eventually make it a high debt company.
The best way to make use of this ratio is to examine a company for trends over a period of time, since this will provide you with more useful information than a single high or low result will.
Cautions & Further Explanation
It’s important to be aware that the result of this ratio may be skewed if a company elects to include amounts in its net income that it has yet to receive.
These are known as accrued revenues, and this can sometimes occur in the case of a very long-term client project where a projected percentage of the final revenues are included as income in each reporting period.
Besides using this ratio as a tool to evaluate potential value of a business, you can also use it with different business valuation ratios so that you can understand better about the company that you are looking to invest in.