This ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.
Here's how dividends "start" and "end." During a fiscal year quarter, a company's board of directors declares a dividend. This event triggers the posting of a current liability for "dividends payable." At the end of the quarter, net income is credited to a company's retained earnings, and assuming there's sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated.
The payment of a cash dividend is recorded in the statement of cash flows under the "financing activities" section.
Note: Zimmer Holdings does not pay a dividend. An assumed dividend amount, as of December 31, 2005, is provided to illustrate the ratio's calculation:
0.80 ÷ 2.96 = 27%
The numerator (annual report or Form 10-K) represents the annual dividend per share paid in cash and the denominator (income statement) represents the net income per share for FY 2005.
In another version of the dividend payout ratio, total amounts are used rather than per share amounts. Nevertheless, an investor should arrive at the same ratio percentage.
Note: In the U.K. there is a similar dividend payout ratio, which is known as "dividend cover". It's calculated using earnings per share divided by dividends per share.
Our first observation states the obvious - you only use this ratio with dividend-paying companies. Investors in dividend-paying stocks like to see consistent and/or gradually increasing dividend payout ratios. It should also be noted that exaggerated (i.e. very high) dividend ratios should be looked at skeptically.
The question to ask is: Can the level of dividends be sustained? Many investors are initially attracted to high dividend-paying stocks, only to be disappointed down the road by a substantial dividend reduction (see remarks below). If this circumstance happens, the stock's price most likely will take a hit.
Secondly, dividend payout ratios vary widely among companies. Stable, large, mature companies (i.e. public utilities and "blue chips") tend to have larger dividend payouts. Growth-oriented companies tend to keep their cash for expansion purposes, have modest payout ratios or choose not to pay dividends.
Lastly, investors need to remember that dividends actually get paid with cash - not earnings. From the definition of this ratio, some investors may assume that dividend payouts imply that earnings represent cash, however, with accrual accounting, they do not. A company will not be able to pay a cash dividend, even with an adequate unrestricted balance in retained earnings, unless it has adequate cash.
In view of this accounting treatment of dividends, it is incumbent upon investors to check a company's dividend payout ratio against an adequate margin of free cash flow to ensure that the payout percentage (ratio) is sustainable.
Proceed to the next chapter on Investment Valuation Ratios here.
Or, click here to return to the Financial Ratio Tutorial main menu.
InvestingDiscover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
InvestingAn investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
InvestingWhy are dividend payout and retention ratios important to consider when investing in company stock? What companies have high ratios?What constitutes a high dividend payout and retention ratio? ...
InvestingDividends may not seem exciting, but they can certainly be lucrative. Learn more here!
InvestingDividends are a significant contributor to total equity returns. That makes dividend payout ratios—which are key indicators of dividend sustainability—doubly important.
InvestingTo find the best dividend stocks, focus on total return, not yield.
InvestingUnderstanding dividends and how they work will help you become a more informed and successful investor.
InvestingLearn about The Boeing Company, its financials and its dividends, which may signal further dividend growth due to its increasing cash flow and earnings.
InvestingLearn some of the primary reasons why dividends constitute a critical factor in the overall performance of a stock investor's portfolio.
InvestingThe payback ratio and retention ratio collect different information and are useful in different situations.