Dividend payout ratio calculation is carried out by taking the yearly dividend per share and dividing it by the earnings per share. This is important because, through this, investors will have an idea of the amount of money a company returns to its shareholders compared to the amount it keeps at hand to reinvest in growth, pay off debts, or add to cash reserves. Through dividend payout ratio calculations, investors have informed decisions with regard to investment.
The dividend payout ratio helps investors in determining the companies that best align with their investment goals. When shareholders invest in a company, their returns on investment comes from two sources which are dividends and capital gains.
The importance will be further elaborated upon in the latter part of this article. We will also look at how to calculate the dividend payout ratio and the formula. Before we go further, let us look at what a dividend payout ratio is and its use in valuing a business.
What is a dividend payout ratio?
The dividend payout ratio is a type of market prospect ratio that determines the percentage of earnings being paid out to shareholders as dividends. In other words, it is the ratio of the total amount of dividends in relation to the company’s net income. It is sometimes referred to as the payout ratio. This financial metric shows the percentage of earnings paid out as dividends to shareholders.
The company retains the amount that is not paid to its shareholders to enable it to pay off debts or reinvest in core operations.
As earlier stated, the dividend payout ratio measures the percentage of net income distributed to shareholders in the form of dividends during a financial period. That is a portion of profits that the company decides to keep in order to fund operations and the portion of profits that is given to its shareholders.
Conversely, some companies want to spur the interest of investors so much that they are willing to pay out unreasonably high dividend percentages. Here, it is easy for investors to see that the company cannot sustain these dividend rates for a long time because it will eventually need money to finance its operations.
There are several considerations to take in the course of interpreting the dividend payout ratio, the company’s level of maturity is an important factor. A new growth-oriented company aiming at expansion, developing new products, and moving into new markets will be expected to reinvest most or all of its earnings. Here, it could be forgiven for having a low or even zero dividend payout ratio. The payout ratio is 0 percent for companies that do not pay dividends to shareholders and 100 percent for companies that pay out their entire net income as dividends to shareholders.
On the other hand, an older and established company that returns a small allowance of money to shareholders would test the patience of investors and has the tendency of tempting activists to intervene. An example is Apple, this company started paying dividends in 2012 after about twenty years since it last made dividend payments. It was when the new CEO felt that the enormous cash flow of the company made a 0% payout ratio difficult to justify. Since it implies that the company has moved further than its initial growth stage, a high payout ratio implies that share prices are unlikely to appreciate in a rapid manner.
Dividend payouts vary widely across industries and just like most ratios, they are most useful to compare within a given industry. For example, Real estate investment partnerships are legally obliged to distribute at least 20% of earnings to shareholders as they enjoy special tax exemptions. Also, Master limited partnerships tend to have high payout ratios as well.
Dividend payout ratio calculation
The dividend payout ratio which is presented as a percentage can be positive or negative. Generally, the ratio will be positive but can be negative if the corporation elects to pay a dividend out of prior earnings in a year when it incurs a net loss.
The ratio itself must be analyzed by taking external factors into account because the results can have multiple meanings or be ambiguous, depending on the specific circumstances of the corporation.
A zero or low payout ratio implies that the company is making use of all its available funds to grow the business. It may also mean that the company does not have earnings to distribute.
On the other hand, a ratio that is close to or exceeds 100% may imply that the corporation is making use of cash reserves to pay dividends and may not be adequately investing earnings back into the business.
The dividend payout ratio calculation takes place in two ways, that is on an individual share basis and on a total share basis. Both formulas end in the same result. So, the factor that determines the formula to be used is the information that the investor has access to. The formulas below will guide on how to calculate the dividend payout ratio.
Before calculating on an individual basis, the earnings per share for the period must be calculated. The formula for calculating the earnings per share is as follows;
Earnings per share = (Net income after tax – Preferred stock dividends) ÷ average number of common shares outstanding
In order to obtain the dividend payout ratio, we will divide the annual dividend paid per share by the earnings per share ratio. This is expressed in the formula below;
Dividend payout ratio = Annual dividend paid per share ÷ Earnings per share
To calculate the dividend payout ratio on a total share basis, we will divide the total dividends paid for the period by the net income for the period. This is also expressed in the formula below;
Dividend Payout Ratio (on a total share basis) = (Total Dividends Paid ÷ Net Income) x 100
Example of dividend payout ratio and calculation
Jackeline is considering investing in Cherry Water Company and needs you to calculate the dividend payout ratios. This company has 10,000 shares of common stock outstanding since the start and does not have shares of preferred stock. Cherry Waer Company has been in business for three years and is growing steadily. At the end of each of the three years, the company has recorded a net income of $100,000, $500,000, and $1,000,000 respectively. The dividends paid for the three years are $0.50 per share, $4.00 per share, and $10.00 per share.
Calculating on a per-share basis
First of all, we would calculate the earnings per share ratio for each year (1 to 3) using the formula and then divide the annual dividend paid per share by the result, that is;
Earnings per share = (Net income after tax – Preferred stock dividends) ÷ average number of common shares outstanding
Dividend payout ratio = Annual dividend paid per Share ÷ Earnings per share
Let us substitute the figures into the formula.
Earnings per share = $100,000 – $0 ÷ 10,000
Earnings per share = $10
Dividend payout ratio = $0.50 ÷ $10
Dividend payout ratio = 5%
Earnings per share = $500,000 – $0 ÷ 10,000
Earnings per share = $50
Dividend payout ratio = $4.00 ÷ $50
Dividend payout ratio = 8%
Earnings per share = $1,000,000 – $0 ÷ 10,000
Earnings per share = $100
Dividend payout ratio = $10.00 ÷ $100
Dividend payout ratio = 10%
Calculating on total share basis
As earlier stated, we can use the formula to achieve the same result on a total share basis. Here, we divide the total dividends paid for the year by the net income to calculate the dividend payout ratio for each year. We can calculate the total dividends paid by multiplying the dividend per share by the number of shares outstanding.
Represented in a formula as;
Total dividends paid = dividend per share x shares outstanding
Let us bring down the formula for calculating the dividend payout ratio on a total share basis for a better understanding.
Dividend Payout Ratio = Total Dividends Paid ÷ Net Income x 100
We can now calculate the total dividend and dividend payout ratio for each year.
Total dividend = $0.50 x 10,000 = $5,000
Dividend payout ratio = $5000 ÷ $100,000 x 100 = 5%
Total dividend = $4.00 x 10,000 =$40,000
Dividend payout ratio = $40,000 ÷ $500,000 x 100 = 8%
Total dividend = $10.00 x 10,000 x 100 = $100,000
Dividend payout ratio = $100,000 ÷ $1,000,000 x 100 = 10%
Dividend payout ratio interpretation
A high dividend payout ratio is an indication that the company is reinvesting less money back into its business while paying out more of its earnings in the form of dividends. Companies as such tend to be attractive to income investors who prefer the assurance of a steady stream of income to high growth potential for growth in share price.
A low dividend payout ratio on the other hand is an indication that the company is reinvesting more in business growth. Here the company may likely be able to generate higher capital gain levels for investors in the future. In this case, these types of companies tend to attract growth investors who have more interest in potential profits from a significant rise in the price of shares and have less interest in dividend income.
The intention of the dividend payout ratio is not to assess whether a company is a good or bad investment. It is rather used to help investors to identify the type of returns a company is more likely to offer to the investor be it dividend income or capital gains. Taking a look at the historical dividend payout ratio helps investors to determine whether the likely investment returns of the company are a good match for the investor’s portfolio, risk tolerance, and investment goals or not. For example, taking a look at dividend payout ratios can be helpful to growth investors or value investors in identifying companies that may be a good fit for their overall investment strategy.
The dividend payout ratio is also useful in gauging a company’s level of maturity such that;
- Companies that are younger or more rapidly growing are more likely to report a low dividend payout ratio as they reinvest most of their earnings into the business for expansion and growth in the future.
- More mature and established companies that have a more steady but probably slower growth rate are more likely to have a relatively high dividend payout ratio as they do not feel the need to reinvest a high percentage of their earnings into business expansion. Blue-chip stocks including Coca-Cola or General Motors usually have dividend payout ratios that are relatively higher.
It is important to note that average dividend payout ratios may vary greatly across industries. Many high-tech industries tend to distribute less or no returns at all in the form of dividends, while companies in the utility industry generally distribute a large portion of their earnings as dividends. By law, real estate investment trusts are required to pay out a very high percentage of their earnings as dividends to investors.
Dividend payout ratio analysis
The dividend payout ratio analysis is important since investors desire to see a stable stream of sustainable dividends from a company. A consistent trend in this ratio usually has more importance than a high or low ratio.
Since companies declare dividends and increase their ratio for one year, a single high ratio is not of great significance. Investors mainly have a concern with regard to sustainable trends. For example, investors can assume that a company that has a 20% payout ratio for the last ten years will continue giving 20% of its profit to the shareholders.
On the other hand, a company with a downward trend of payouts is alarming to investors. For example, if the ratio of a company has fallen by a percentage each year for the previous five years, this might be an indication that the company can no longer afford to pay such high dividends. Also, this can be an indication of poor performance in its operations. Generally, companies that are more mature and stable tend to have a higher ratio than new start-up companies.
How to analyze a dividend payout ratio
The payout ratio can serve as a warning stating that there is a need to look deeper than a simple red or green light signal to investors to buy or sell.
Investors that are income-oriented prize a high payout ratio because it produces the biggest quarterly check possible, however, a low ratio or no dividend at all is not necessarily bad. It depends on the manner in which a firm uses its income. A company can invest its profits in research and development or expansion to increase earnings or hopefully drive up share prices for instance, or the company can use its earnings to buy back shares, reducing the number in circulation to help in pushing up the share price.
Many growth-oriented investors prefer profits to be reinvested or used for buybacks. This is because investors gain from prices that are not taxed until after the sales of the shares, while dividends are taxed in the year they are received.
So now, a stock that has a low payout ratio may be a good bet. If there is little or no dividend, investors that are in need of income can sell some shares from time to time. There is a difference between the manner in which startups or smaller companies treat their dividends and the manner in which larger or more established companies do.
If a company is at the stage of growth, it may not be able to afford a higher dividend since it is likely to reinvest most of its earnings back into the company to finance its operations. While companies at all phases may be focused on growth, a company with a more developed business can distribute higher dividends to its shareholders.
A low dividend in general terms indicates that the company has enough earnings to support future dividend distributions or sustain a rising dividend payout, this is actually a good sign.
A high payout can pose a risk of the company not allocating enough funds for growth, innovation, research, development, etc.
It is therefore helpful to take a look at a company’s earnings alongside evaluating its payout ratio. If the earnings of a company are increasing, it may be in a position to increase its dividend in the future.
When investors see a consistent increase in dividend payments, it can be an indication that the company is financially stable with more room for growth. On the other hand, for a company whose earnings may not be able to afford an increase in dividend payment, the dividend may remain stagnant or worse.
Importance of dividend payout ratio
The dividend payout ratio indicates the amount shareholders get back in the form of percentage returns from the overall profit that the company earns. This metric is also important because it helps in determining how the business is functioning or operating, that is whether it has enough growth potential or not.
A ratio that is substantially high indicates the maturity of the management, showing the concern about providing value in addition to its shareholders. A ratio that is abnormally high can be alarming because sometimes, it indicates that the net income of the company is diminishing but still the company prefers to release dividends to its shareholders.
The dividend payout ratio is useful for the assessment of dividend sustainability. Companies are oftentimes reluctant to cut down dividends since it can drive the stock price down and reflect poorly on the abilities of the management. If a company’s payout ratio is 100% and above, it is returning more money to shareholders than it is earning. This will probably force the company to lower the dividend or stop paying it altogether, however, this result is not inevitable.
The dividend payout ratio provides an indication of the amount of money a company is returning to shareholders versus the amount it is keeping on hand to reinvest in growth, pay off debts, or add to cash reserves (retained earnings). Through this ratio, investors establish how dividend payments were made in the past to predict how dividend payments will be made in the future.
Investors particularly are interested in the dividend payout ratio because they want to know if companies are really paying out a reasonable portion of net income to them. For instance, it is rare for most start-up companies and tech companies to give dividends at all. Apple, a company formed in the 1970s gave out its first dividend to shareholders in 2012. As stated at the beginning of this article, through dividend payout ratio calculations, investors have informed decisions with regard to investment. Also, investors are able to know the companies that align with their investment goals.
Why is the dividend payout ratio important?
The dividend payout ratio as we all know is a financial metric used in determining the sustainability of a company’s dividend payment program. This metric indicates the amount of money a company is returning to shareholders compared to the amount it is keeping to reinvest, pay off debts, or add to cash reserves. Investors are particularly interested in the dividend payout ratio to enable them to know if companies are paying a reasonable portion of net income to them. In essence, investors make informed investment decisions through this financial metric. The dividend payout ratio is also important in indicating the maturity of a company.