Loading the player...

What is '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 tied to the company’s long-run, sustainable earnings.

Target payout ratio is expressed as (dividends per share / earnings per share)

BREAKING DOWN 'Target Payout Ratio'

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

Choosing a Target Payout Ratio

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; in other words, 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 equity requirements 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.

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 level.

RELATED TERMS
  1. Payout Ratio

    Payout ratio is the proportion of earnings paid out as dividends ...
  2. Dividend

    A dividend is a distribution of a portion of a company's earnings, ...
  3. Dividend Signaling

    Dividend signaling suggests that a company announcement of an ...
  4. Forward Dividend Yield

    A forward dividend yield is an estimation of a year's dividend ...
  5. Residual Dividend

    Residual dividend is a policy applied by companies when calculating ...
  6. Accelerated Dividend

    An accelerated dividend is a special dividend that a company ...
Related Articles
  1. Investing

    Dividend Ratios: Payout And Retention

    The dividend payout ratio and retention ratio measure how much profit a company gives back to shareholders as dividends. When a business earns money, it must decide whether to use all of its ...
  2. Investing

    How Dividends Affect Stock Prices

    Find out how dividends affect the underlying stock's price, the role of market psychology, and how to predict price changes after dividend declarations.
  3. Investing

    A Guide For Calculating The Dividend Payout Ratio

    Dividends are a significant contributor to total equity returns. That makes dividend payout ratios—which are key indicators of dividend sustainability—doubly important.
  4. Investing

    6 Winning Ways for Successful Dividend Investing

    There are some important rules to maximize dividend investing value.
  5. Investing

    Payout Ratio vs. Retention Ratio: When to Use Which

    The payback ratio and retention ratio collect different information and are useful in different situations.
  6. Insights

    Do Interest Rate Changes Affect Dividend Payers?

    Interest rate changes have an effect on prices of dividend-rich stocks in interest rate sensitive sectors like utilities, pipelines, telecommunications and REITs.
  7. Investing

    AAPL: Apple Dividend Analysis

    Apple's dividend has had healthy growth ever since its 2012 reinstatement, thanks to Apple's continuously rising revenue, earnings and operating cash flow.
  8. Investing

    WMT: Wal-Mart Dividend Analysis

    Wal-Mart raised its dividend for the 43rd consecutive year, despite losing over 25% of its market value in 2015, and its dividend remains healthy in 2016.
  9. Investing

    Why dividends matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
RELATED FAQS
  1. Do I receive the posted dividend yield every quarter?

    Learn how companies with stock that pays dividends will typically distribute the dividend each quarter. Find out how much ... Read Answer >>
  2. Cash Dividends or Stock Dividends: Which is better?

    The purpose of dividends is to return wealth back to the shareholders of a company. There are two types of dividends: cash ... Read Answer >>
  3. Can dividends be paid out monthly?

    Find out how stocks can pay dividends monthly and learn about the types of industries or companies that will most likely ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center