What is Dividend Payout Ratio?
The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company. It is the percentage of earnings paid to shareholders in dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or to reinvest in core operations.
Dividend Payout Ratio
Breaking Down Dividend Payout Ratio
The dividend payout ratio provides an indication of how much money a company is returning to shareholders versus how much it is keeping on hand to reinvest in growth, pay off debt, or add to cash reserves (retained earnings). The dividend payout ratio can be calculated as the yearly dividend per share divided by the earnings per share, or equivalently, the dividends divided by net income (as shown below):
Alternatively, the dividend payout ratio can also be calculated as 1 - Retention Ratio
How to Interpret the Ratio
Several considerations go into interpreting the dividend payout ratio, most importantly the company's level of maturity. A new, growth-oriented company that aims to expand, develop new products, and move into new markets would be expected to reinvest most or all of its earnings and could be forgiven for having a low or even zero payout ratio.
On the other hand, an older, established company that returns a pittance to shareholders would test investors' patience and could tempt activists to intervene. In 2012 and after nearly twenty years since its last paid dividend, Apple (AAPL) began to pay a dividend when the new CEO felt the company's enormous cash flow made a 0% payout ratio difficult to justify. Since it implies that a company has moved past its initial growth stage, a high payout ratio means share prices are unlikely to appreciate rapidly.
The payout ratio is also useful for assessing a dividend's sustainability. Companies are extremely reluctant to cut dividends since it can drive the stock price down and reflect poorly on management's abilities. If a company's payout ratio is over 100%, it is returning more money to shareholders than it is earning and will probably be forced to lower the dividend or stop paying it altogether. That result is not inevitable, however. A company endures a bad year without suspending payouts, and it is often in their interest to do so. It is therefore important to consider future earnings expectations and calculate a forward-looking payout ratio to contextualize the backward-looking one.
Long-term trends in the payout ratio also matter. A steadily rising ratio could indicate a healthy, maturing business, but a spiking one could mean the dividend is heading into unsustainable territory.
Dividends Are Industry Specific
Dividend payouts vary widely by industry, and like most ratios, they are most useful to compare within a given industry. Real estate investment partnerships (REITs) , for example, are legally obligated to distribute at least 90% of earnings to shareholders as they enjoy special tax exemptions. Master limited partnerships (MLPs) tend to have high payout ratios, as well.
Dividends are not the only way companies can return value to shareholders; therefore, the payout ratio does not always provide a complete picture. The augmented payout ratio incorporates share buybacks into the metric; it is calculated by dividing the sum of dividends and buybacks by net income for the same period. If the result is too high, it can indicate an emphasis on short-term boosts to share prices at the expense of reinvestment and long-term growth.
Another adjustment that can be made to provide a more accurate picture is to subtract preferred stock dividends for companies that issue preferred shares.