What Is the Payout Ratio?
The payout ratio shows the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage of the company's earnings. The payout ratio can also be expressed as dividends paid out as a proportion of 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 that is paid out as dividends to shareholders.
- A low payout ratio can signal that a company is reinvesting the bulk of its earnings into growing the business.
- A payout ratio over 100% indicates that the company is paying out more in dividends than it is earning.
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 payments. It is the amount of dividends paid to shareholders relative to the total net income of a company. For example, Company X has earnings per share of $1 and pays dividends per share of $0.60, which would give a payout ratio of 60%.
Company Y has earnings per share of $2 and dividends per share of $1.50 which gives a payout ratio of 75%. Company X pays out a smaller percentage of its earnings to shareholders as dividends, giving it a more sustainable payout ratio than Company Y.
However, if Company X is a commodity producer and Company Y is a regulated utility, Y’s dividend sustainability may be better than that of X, even though X has a lower absolute payout ratio than Y.
Dividends are paid out of a company's net earnings and represent a return on investment to shareholders. Each year, when a company decides to pay dividends to shareholders it declares a dividend payment and the amount of dividend per share.
There is no single number that defines an appropriate payout ratio. The adequacy of the payout ratio depends very much on the sector. Companies in defensive industries, such as utilities, pipelines, and telecommunications, have stable and predictable earnings and cash flows and thus can support much higher payouts than cyclical companies. Companies in cyclical sectors, such as resources and energy, typically have lower payouts since their earnings fluctuate considerably in line with the economic cycle.
Example of How to Use the Payout Ratio
Assume that Company ABC, Inc. reported net income of $100,000 for the year. For the same time period, ABC, Inc. declared a dividend and issued a total of $25,000 in dividends to its shareholders. The payout ratio would be $25,000 / $100,000 = 25%.
This shows that ABC, Inc is paying out 25% of net income to its shareholders, and the company keeps the other 75%, recorded on its financial statements as retained earnings, for investing in growing the business.
Some companies pay out all their earnings to shareholders, while some only pay out a portion of their earnings. If a company pays out some of its earnings as dividends, the remaining portion is retained by the business. To measure the level of earnings retained, the retention ratio is calculated. A lower payout ratio indicates that the company is using more of its earnings to reinvest in the company in order to grow further. In this case, the retention ratio will be high.
A high payout ratio may mean that the company is sharing more of its earnings with its shareholders. If this is the case, the retention ratio will be low. A payout ratio greater than 100% may be interpreted to mean that the company is paying out more in dividends than it is earning, which is an unsustainable move.
Many companies set a target range for their payout ratios and define them as a percentage of sustainable earnings, or cash flow. The companies with the best long-term record of dividend payments have stable payout ratios over many years. While many blue-chip companies increase their dividends year after year, since they have steady earnings growth as well, their payout ratios remain remarkably stable over extended periods.