Target Payout Ratio

What is the Target Payout Ratio?

A target payout ratio is a measure of the percentage of a company's earnings it would like to pay out to shareholders as dividends over the long-term. Firms are conservative in setting their target dividend payout ratio with the goal of being able to maintain a stable dividend level while also retaining enough capital to grow and/or operate the business efficiently.

Sometimes the payout ratio is equal to the target payout ratio. Other times the payout ratio—which is dividends per share divided by earnings per share—may be higher or lower than the target rate because earnings fluctuate from quarter to quarter and year to year.

Understanding the Target Payout Ratio

Since dividend cuts are perceived negatively by markets, management teams are usually reluctant to increase dividends unless they are fairly confident they will not have to reverse their decision due to cash flow pressure in the near future.

Firms strive for a stable dividend level that aligns their stock’s dividend growth rate with the company's long-term earnings growth to provide a steady dividend over time. A company with a stable dividend policy can choose to use a target payout ratio adjustment model to gradually move toward its target payout as its earnings rise.

Expected dividend = (previous dividend) + [(expected increase in EPS) x (target payout ratio) x (adjustment factor)]

where: adjustment factor = (1 / # of years over which the adjustment in dividends will take place)

A company with a residual dividend model, where its stock dividends are based on the amount of residual earnings left over after the company has paid all its expenses and other obligations, can also use a target payout ratio.

The following steps can be followed to determine the target payout ratio:

1. Identify the optimal capital budget allocation. This is the proportion of the budget that is financed with equity versus debt financed.
2. Determine the amount of equity needed to finance that capital budget for a given capital structure.
3. Meet obligations to the maximum extent possible with retained earnings.
4. Pay shareholder dividends using the "residual" earnings that are available after the needs of the optimal capital budget are supported. This residual dividend policy implies that dividends are paid out of leftover, residual, earnings.

In the residual dividend model, the amount of dividends shareholders receive may not always be stable, but if the company is using targets at least the process for determining the amount of dividends is stable.

Companies that use the stable dividend model typically strive for stable payments that generally increase over time assuming earnings continue to grow.

Dividends and Stock Prices

Investors closely follow information related to dividend payout, and stock prices often react poorly to unexpected changes in a company’s target payout ratio. Because of the message that dividend policy can send about a company’s prospects, company managements share payout guidance as well as planned changes to target payout ratios. Stock analysts particularly want to understand a company’s dividend policy and payout strategy as well as how it compares to the industry.

A payout ratio or target payout ratio that is too high could send a negative signal to the market, and may actually put downward pressure on the stock price since investors and analysts may feel the company isn't retaining enough capital to grow or operate as effectively as it could.

A low payout ratio or target payout ratio will typically need to be accompanied by stronger earnings growth prospects in order to attract investors, this way shareholders are compensated through likely share price appreciation instead of dividends. If the company is profitable, yet not growing, investors may question why the company isn't paying out more in dividends to shareholders.

Older companies with minimal growth prospects typically pay out more in dividends since this is how shareholders are rewarded. With little growth in the company, the stock price is no longer likely to explode higher.

Example of Target Dividend Policy

As of 2019, the big box retailer Target Corporation (TGT) has maintained an increasing dividend policy every year for more than 50 years. In 1967 the company paid $0.0021 per share. In 2018, Target paid $2.52 per share, and increased the dividend for 2019.

Typically the company has increased the dividend by at least a couple cents per year going back to 2001. Prior to this, Target still increased the dividend each year, but increases were a penny or fractions of a penny each year.

As of May 2019, the company has a payout ratio of approximately 45%. The company has maintained its increasing dividend policy even though earnings have not increased each year. This means that in some years the payout ratio will be higher than in others.

At 45%, there is room for fluctuation, as earnings would need to drop considerably for Target to be paying out 100% of its earnings in dividends. Too high of a payout ratio may worry investors. If earnings increase over the years, at a greater rate than the dividend increases, the payout ratio will drop. If dividends increase at a greater rate than earnings, the payout ratio will increase.