When comparing the two measures of dividends, it's important to know that the dividend yield tells you what the simple rate of return is in the form of cash dividends to shareholders, but the dividend payout ratio represents how much of a company's net earnings are paid out as dividends. While dividend yield is the more commonly known and scrutinized term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company's cash flow.
Current shareholders and potential investors would do well to evaluate both the yield and payout ratio.
What Is the Dividend Yield?
The dividend yield shows how much a company has paid out in dividends over the course of a year. The yield is presented as a percentage, not as an actual dollar amount. This makes it easier to see how much return per dollar invested the shareholder receives through dividends.
The yield is calculated as follows:
Dividend Yield = Annual Dividends per Share / Price per Share
For example, a company that paid out $10 in annual dividends per share on a stock trading at $100 per share has a dividend yield of 10%. You can also see that an increase in share price reduces the dividend yield percentage and vice versa for a decline in price.
However, dividend yields can be misleading on their own. Some companies pay out dividends even when they are operating at a short-term loss. Others may pay out dividends too aggressively, failing to reinvest enough capital into their business to maintain profitability down the road. This is where the dividend payout ratio can come in handy.
What Is the Dividend Payout Ratio?
This financial ratio highlights the relationship between net income and dividend payments to shareholders. This figure is not always prominently displayed when evaluating stocks, but you can always look for income and dividend entries on the issuing company's balance sheet.
Put another way, the dividend payout ratio shows whether the dividend payments made by a company make sense given their earnings. If the number is too high, it may be a sign that too small a percentage of the company's profits are being reinvested for future operations. This casts doubt on the company's ability to maintain high dividend payments.
The payout ratio is calculated as follows:
Dividend Payout Ratio = Annual Dividends per Share / Earnings per Share.
Whenever possible, compare dividend payout ratios over a period of time. It is a sign of good management and financial health if the dividend payout ratios are historically stable or trending upward at a reasonable clip.
In extreme cases, dividend payout ratios may exceed 100%, meaning more dividends were paid out than there were profits that year. Significantly high ratios are unsustainable. Companies that have stable payout ratios and relatively high dividend yields are the most attractive options for investors.