It doesn't matter whether you're a new investor or a seasoned pro. Knowing what factors to consider when you create a new portfolio or rebalance an existing one is very important. After all, market conditions can threaten potential returns. But what metrics should you consider when making those all-important decisions?

Investors use many different ratios and metrics when weighing which companies to add to their portfolios. Among them is the dividend payout ratio (DPR), which looks at dividends paid out relative to a company's total net income. Read on to find out more about this metric, what it means, and how it can be interpreted.

Key Takeaways

• The dividend payout ratio is a comparison of total dollars paid out to shareholders relative to net income.
• This ratio is an important aspect of fundamental analysis that can be calculated using data easily found on a company's financial statements.
• DPR is commonly calculated on a per share basis by dividing annual dividends per common share by earnings per share.

What Is a Dividend Payout Ratio?

The dividend payout ratio is a comparison of total dollars paid out to shareholders relative to the net income of a company. It is the percentage of a company's earnings used to reward its investors. The dividend payout ratio is an important aspect of fundamental analysis that can be calculated using data easily found on a company's financial statements. This ratio indicates what percentage of net income a company devotes to paying cash dividends to shareholders.

It is also considered to be the net income that a company does not reinvest in the business, use to pay off debt, or add to its cash reserves. As such, the payout ratio is the opposite of the retention ratio, which shows what amount of earnings the company holds onto to reinvest back into its operations.

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How to Calculate the Dividend Payout Ratio

The dividend payout ratio can be calculated on an absolute basis by dividing the total annual dividend payout amount by net income. But it is more commonly calculated on a per share basis. Here's the formula:

DPR = Annual Dividends per Common Share รท Earnings Per Share

The payout ratio can be determined using the total common shareholders' equity figure shown on a company's balance sheet. Divide this total by the company's current share price to get the number of outstanding shares. Then calculate dividends per share by dividing the dividend payout amount shown on the balance sheet by the number of outstanding shares.

The earnings per share (EPS) figure can be found at the bottom of the company's income statement.

Interpreting the Dividend Payout Ratio

The dividend payout ratio is a key profitability ratio that measures return on investment. By revealing what percentage of net income a company pays out or retains, it can also serve as a metric to gauge a company's future prospects.

The dividend payout ratio can serve as a metric to gauge a company's future prospects.

A high dividend payout ratio is not always valued by active investors. An unusually high dividend payout ratio can indicate that a company is trying to mask a bad business situation from investors by offering extravagant dividends, or that it simply does not plan to aggressively use working capital to expand.

Analysts prefer to see a healthy balance between dividend payouts and retained earnings. They also like to see consistent dividend payout ratios from year to year that indicate a company is not going through boom-and-bust cycles. Stock traders, as opposed to buy-and-hold investors, tend to dismiss stock dividends, as they don't intend to hold their investments long enough to get them.

In recent years, companies riding the crest of a business boom have paid little or no dividends to their investors. During the technology boom of the late 1990s, it was even seen as a signal that a company was maturing into comfortable, but not spectacular growth.

Considerations for DPRs

One of the factors to consider when it comes to the DPR is a company's maturity. New companies may pay out a low DPR or even none at all. This may mean that a company is still fairly new and is concentrating on growth: research and development (R&D), new product lines, or expansion into new markets. A company that's more established may disappoint investors if it doesn't pay out any dividends at all, especially if it's gone well past its expansion and growth stages.

DPRs and Dividend Sustainability

Dividend payout ratios can also help determine how whether a company is able to sustain its dividend. The general range for a healthy DPR falls between 35% to 55%. This means the company is returning about half of its earnings to shareholders, and is reinvesting the remaining half in order to grow. This kind of payout ratio indicate a more sustainable dividend.

A company whose DPR is over 100% tends to be unsustainable. It means that it's returning more money to its shareholders than it earns. The company may have to lower the dividend or, even worse, stop paying it out. But this scenario is not very likely since many companies feel cutting their dividends can cause share prices to drop. It may also lead investors to lose faith in the management teams of dividend-paying companies.

The Bottom Line

The dividend payout ratio continues to be a key factor in selecting stocks, particularly for the long term. Professional portfolio managers generally recommend that an investor devote some portion of a portfolio to such income-generating stocks. The recommended portion devoted to such stocks generally increases as the investor approaches retirement.