Target Payout Ratio

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DEFINITION of 'Target Payout Ratio'

A target payout ratio is a measure of what size a company's dividends should be. Firms generally determine their target payout ratio through a stable dividend policy tied to long-run, sustainable earnings. They are usually reluctant to increase dividends unless a reversal is not expected in the near future.

Target Payout Ratio = (dividends per share / earnings per share)

Firms strive for a stable dividend policy to align their dividend growth rate with the company's long-term earnings growth rate to provide a steady dividend over time. A company with a stable dividend policy can choose to use a target payout ratio adjustment model to gradually move towards its target payout.

Expected dividend = (previous dividend) + [(expected increase in EPS) x (target payout ratio) x (adjustment factor)]
where: adjustment factor = (1 / # of years over which the adjustment in dividends will take place)

BREAKING DOWN 'Target Payout Ratio'

A company with a residual dividend model, where the dividends are based on the amount of residual earnings left over after the company pays all its expenses and obligations, can also use a target payout ratio.

The following steps are followed to determine the target payout ratio:

  • Identify the optimal capital budget allocation, or what proportion of the budget comes from equity vs. debt financing
  • Determine the amount of equity needed to finance that capital budget for a given capital structure.
  • Meet equity requirements to the maximum extent possible with retained earnings.
  • Pay dividends with the "residual" earnings that are available after the needs of the optimal capital budget are supported. The residual dividend policy implies that dividends are paid out of leftover earnings.