The payout ratio is a financial metric showing the proportion of earnings a company pays shareholders in the form of dividends, expressed as a percentage of the company's total earnings. On some occasions, the payout ratio refers to the dividends paid out as a percentage of a company's cash flow. The payout ratio is also known as the dividend payout ratio.
The Formula for the Payout Ratio Is
DPR=Net incomeTotal dividendswhere:DPR=Divided payout ratio (or simply payout ratio)
Dividend Payout Ratio
- The payout ratio, also known as the dividend payout ratio, shows the percentage of a company's earnings paid out as dividends to shareholders.
- A low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations.
- A payout ratio over 100% indicates that the company is paying out more in dividends than its earning can support, which some view as an unsustainable practice.
What Does the Payout Ratio Tell You?
The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payment program. It is the amount of dividends paid to shareholders relative to the total net income of a company. For example, let's assume Company ABC has earnings per share of $1 and pays dividends per share of $0.60. In this scenario, the payout ratio would be 60% (0.6 / 1). Let's further assume that Company XYZ has earnings per share of $2 and dividends per share of $1.50. In this scenario, the payout ratio is 75% (1.5 / 2). Comparatively speaking, Company ABC pays out a smaller percentage of its earnings to shareholders as dividends, giving it a more sustainable payout ratio than Company XYZ.
While the payout ratio is an important metric for determining the sustainability of a company’s dividend payment program, other considerations should likewise be observed. Case in point: in the aforementioned analysis, if Company ABC is a commodity producer and Company XYZ is a regulated utility, the latter may boast greater dividend sustainability, even though the former demonstrates a lower absolute payout ratio.
In essence, there is no single number that defines an ideal payout ratio because the adequacy largely depends on the sector in which a given company operates. Companies in defensive industries, such as utilities, pipelines, and telecommunications, tend to boast stable earnings and cash flows that are able to support high payouts over the long haul. On the other hand, companies in cyclical industries typically make less reliable payouts, because their profits are vulnerable to macroeconomic fluctuations. In times of economic hardship, people spend less of their incomes on new cars, entertainment, and luxury goods. Consequently, companies in these sectors tend to experience earnings peaks and valleys that fall in line with economic cycles.
Example of How to Use the Payout Ratio
Some companies pay out all their earnings to shareholders, while others dole out just a portion and funnel the remaining assets back into their businesses. The measure of retained earnings is known as the retention ratio. The higher the retention ratio is, the lower the payout ratio is. For example, if a company reports a net income of $100,000 and issues $25,000 in dividends, the payout ratio would be $25,000 / $100,000 = 25%. This implies that the company boasts a 75% retention ratio, meaning it records the remaining $75,000 of its income for the period in its financial statements as retained earnings, which appears in the equity section of the company's balance sheet the following year.
Generally speaking, companies with the best long-term records of dividend payments have stable payout ratios over many years. But a payout ratio greater than 100% suggests a company is paying out more in dividends than its earnings can support.