The dividend payout ratio is a comparison of the total dollars paid out to shareholders relative to the net income of a company. It is the percentage of a company's earnings that is used to reward its investors.

Looked at differently, it is the net income that a company does not reinvest in the business, use to pay off debt, or add to its cash reserves.

How Dividend Payout Ratio Is Used

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.

The dividend payout ratio indicates what percentage of net income a company devotes to paying cash dividends to shareholders.

Thus, 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.

How to Calculate It

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:

Dividend payout ratio = annual dividends per common share รท earnings per share

The payout ratio can be done 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.

What It Means

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

However, 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.

Nonetheless, 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.