Understanding the Dividend Payout Ratio

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Investors use many different ratios and metrics to assess viable candidates for their portfolios. One of these is the Dividend Payout Ratio (DPR), which looks at the dollar amount of dividends a company pays out, relative to its total net income.

What the Dividend Payout Ratio Tells You

The DPR expresses what percentage of earnings the company paid out to its owners or shareholders. Any money the company doesn't pay out typically goes to pay down the firm's debt or reinvest in key operations. The DPR alone cannot define a company's health but it gives a sense for how the company prioritizes investment in future growth.

How to Calculate Dividend Payout Ratio

You can calculate the DPR by dividing the dividends per share by the company's earnings per share:

DPR = Dividends Per Share / EPS

For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would be 33%. ($1 / $3 = 33%)

How to Interpret the Dividend Payout Rate

The real question is whether 33% equates to a good or bad payout, which varies depending on the interpretation. Growing companies typically retain more profits to fund growth, which offers the chance of more favorable dividends in the future, while offering lower or no dividends in the present.

Companies paying higher dividends may be in mature industries with little room for additional growth, so paying higher dividends may be the best use of profits. An industry with one specific product line would fall into this group. If that industry began to diversify—one good example is utility companies—it would become more appropriate to divert some profits into future investment.

How to Evaluate Dividend Sustainability

You can infer other information about a company's strength with the DPR, such as the dividend's level of sustainability. Companies have a motivation to pay dividends at a level they know they can sustain, rather than offering an aggressive dividend to please shareholders. Some companies have learned the hard way that cutting dividends upsets shareholders, drives down the company's stock price, and reflects poorly on the management team's abilities.

Following a firm's dividend payment trends over time sheds additional insight. If a company's DPR rises over time, it could indicate the company's maturing into a healthy and stable operation. Conversely, if the dividend spikes up, the company could have trouble sustaining such a high dividend in future periods.

Regardless, it's important to view the DPR in the context of the company, its industry, and its competitors. Although the ratio offers some insight, companies provide shareholder value in other ways than dividend payments. For instance, having enough cash flow to avoid taking on debt has value in the long-term.

One important rule of thumb: If a company's dividend payout ratio exceeds 100%, the company is paying out more in dividends than the cash it is taking in. This is not a sustainable strategy over time if the company wishes to remain in business. Companies sometimes do this if they are losing money and don't want shareholders to sell the stock.

Thus, tracking changes in a firm's DPR over time provides much more meaningful analysis.