What is a Dividend Payout Ratio?
What is a good dividend payout ratio?
How do you calculate it?
In this article, I will break down the notion of the Dividend Payout Ratio so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let me explain to you what dividend payout ratio means and why it’s important!
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Table of Contents
What Is Dividend Payout Ratio
The dividend payout ratio refers to the measure of the amount of cash a company pays out to its shareholders in relation to the company’s net income.
In other words, with the dividend payout ratio, you can determine what is the percentage of earnings the company distributes to its shareholders in the form of dividends.
For example, if a company has $1,000,000 in net income and chooses to pay $10,000 in dividends to its shareholders, then the company’s payout ratio is 2% ($20,000 over $1,000,000).
When a company has a high dividend payout ratio, it means that it is distributing a lot of its earnings as dividends to its shareholders and keeps a smaller portion to reinvest in its business.
On the other hand, if a company does not pay any dividends and reinvests all of its net income back into the business, it will have a dividend payout ratio of zero.
Historically, according to the Wellington Management and Hartford Funds research, a safe dividend payout ratio is approximately around 41%.
Assessing Dividend Payout Ratio
Investors and finance professionals look at a company’s dividend payout ratio to get a better sense of the company’s ability to pay dividends over time.
When analyzing a company’s dividend payout ratio (DPR), you can tell how much the company is paying dividends to its shareholders in relation to its net income.
Looking at the company’s historical dividend payout ratio or the average dividend payout ratio in the industry can provide a good indication of how the company is doing over time and in relation to its peers.
For example, a company that regularly pays dividends and that has a track record of steadily increasing its dividends payout ratio is one that is financially mature and healthy.
On the other hand, a company that is reducing its payout ratio or that is payout ratio has been declining compared to the industry average is one that may have more difficulty sustainably paying dividends over time.
The opposing concept to the dividend “payout” ratio is the “retention” ratio.
In essence, when a company chooses to distribute money to its shareholders in the form of dividends, we can use the ratio of the dividends to calculate how much it is paying out.
On the flip side, the amount of money the company chooses to keep in the business can be calculated by the company’s retention ratio.
If a company does not pay any dividends to its shareholders and retains all its net income, it will have a 100% retention ratio and a 0% dividend payout ratio.
Why Is The Dividend Payout Ratio Important
The dividend payout ratio is an important ratio to consider when evaluating a company’s stock for investment or to assess the company’s financial position.
One of the most important pieces of information that the “dividend payout ratio” provides is a glimpse into the company’s cash management and financial maturity.
For instance, a well-established company generating consistent business income can choose to pay a good dividend payout ratio and still continue earning enough money to build its cash reserves, pay off debt, or invest in growing the business.
On the other hand, a company with a very low div payout ratio (or even zero) is a type of company where its management considers that reinvesting most (if not all) of its earnings back into the business will generate a better return to its shareholders.
Typically, startups, new ventures, and rapidly growing companies do not pay any dividends as they need all the money they can get to finance their growth and expansion.
Dividend Payout Formula
What is the dividend payout formula?
Here is the dividend payout formula:
Dividend Payout Ratio = Dividends / Net Income
As you can see from this formula, to get the ratio between the dividends paid and the company’s net income, we’ll need to divide the amount of dividends paid by the company’s net income.
You can also calculate the dividend payout ratio by using the following formula:
With this formula, you are essentially calculating the company’s dividend payout ratio by using per share figures.
There is a third method you can use to calculate DPR and the formula is expressed as follows:
Dividend Payout Ratio = 1 – Retention Ratio
The retention ratio is the amount of net income the company keeps as retained earnings.
How To Calculate Dividend Payout Ratio
Let’s look at how you can calculate the dividend payout ratio.
Imagine that you have a company that has the following financial position:
- Net income: $10,000,000 per year
- Retained earnings: $50,000,000
This company has a lot of retained earnings that have accumulated over the past years and can use that money to finance its business without having to reinvest 100% of its net income back into the business.
The company management decides to pay dividends to its shareholders in order to compensate them for staying loyal.
The company’s board of directors declares the following dividends for the next four quarters:
- Q1: $500,000
- Q2: $500,000
- Q3: $500,000
- Q4: $500,000
This means that the company’s annual dividend payout ratio is the total of all the dividends it paid out ($2,000,000) over its net income ($10,000,000) representing a ratio of 20%.
This means that the company will 20% of its net income to pay dividends to its shareholders and keep 80% as retained earnings, to pay off debt on its balance sheet, or invest in the business.
Dividend Payout Ratio By Industry
What is the best dividend payout ratio?
The answer is that it depends on what type of company you are evaluating, which industry, the company’s future plans, and so on.
Calculating the ratio dividend payout can give an indication of a company’s dividend payment sustainability or business maturity, but it does not tell the full story by itself.
To better understand a company’s financial position, it’s worth looking at the industry dividend payout ratio to see where a company is situated compared to its industry or competitors.
Every industry will have its own characteristics.
For example, if you are assessing real estate investment trusts (REITs), you should expect payout ratios of no less than 90% as they are legally required to distribute at such high levels to benefit from various tax exemptions.
If you are considering Master Limited Partnerships (MLPs), you should expect to see high payout ratios.
On the other hand, companies in the technology space or high-tech tend to have a zero dividend payout ratio (or very low percentages) as they typically invest all their money back into growing the business.
Stock Dividend Payout Ratio Takeaways
So, there you have it folks!
In a nutshell, the dividend payout ratio represents a measure of how much money a company is paying out to its shareholders and how much it is keeping to reinvest in the business, keep as retained earnings, or pay off debt obligations.
Companies with high dividend payout ratios are companies that pay out most of their earnings as dividends to their shareholders.
The main reason why you’d want to measure how much a company is paying dividends to its shareholders in relating to the money it makes is to see whether or not the company has the ability to sustainability pay dividends.
Having a high dividend payout ratio may seem attractive for investors as they can get a higher cash flow on their investments.
However, if a company is aggressively paying out dividends and is not using its net income adequately to fund the business operations, pay debt, or build cash reserves for acquisitions or other capital expenditures, not only the investor’s dividends may be at risk long-term but the business as well.
Now, you understand the meaning of dividend payout ratio, why it’s important, how its calculated, and what it tells you.
Good luck with your next investment!!
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Dividend Payout Ratio Meaning Summary
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