What is meant by Dividend Payout Ratio?
The ratio of the total amount of dividends paid out to shareholders compared to the net income company’s is known as the dividend payout ratio. Hence, this metric is the percentage of earnings paid out to shareholders in the form of dividends. The company holds the amount that is not paid off to shareholders to pay off debt or reinvest it in core operations. Some refer to this ratio only as ‘payout ratio.’ The dividend ratio comes in handy as an indication of the amount of money returned to shareholders versus how much is kept to reinvest in growth, debt, or added as retained earnings to cash reserves.
When it comes to interpreting the dividend payout ratio, several aspects of the company are considered. The most important criterion is how mature the company is. The company’s maturity level is vital when it comes to its dividend payout ratio. A relatively new company will have goals around expansion, such as developing new products, moving into markets, and other growth-oriented objectives. Such a company would attempt to reinvest most, if not all, of its earnings, and it could also be forgiven for having relatively low or even zero payouts.
Dividend Ratio Payout Formula
The ratio of Dividend Payout can be calculated based on the yearly dividend earned per share. This estimate will then be divided by the earnings per share or the dividends divided by one’s net income. Hence, the Dividend Ratio Payout Formula is
Dividends Paid/Net Income = Dividend Payout Ratio
Alternatively, the ratio for dividend payout can also be calculated using the metric of retention ratio as follows:
1 – Retention Ratio = Dividend Payout Ratio
What does the Dividend Payout Ratio reveal?
As mentioned earlier, several considerations go into interpreting a dividend payout ratio, with the most important of these being the level of maturity a company possesses. A new growth-oriented company would be predicted to reinvest most of its earnings and would have a nearly zero ratio. On the other hand, a company that is well established and older would return a pittance to its shareholders. Such a company would test the patience of investors and may also tempt any activists from intervening.
Another critical assessment of the dividend payout ratio is dividend sustainability. A company can be extremely reluctant to cut dividends as this can drive down its stock price and look bad for its management capability. On the other hand, with a payout ratio of over 100%, a company will be returning more money to shareholders than it is currently earning. Hence, such a company will be forced to either lower its dividend or stop paying it altogether.
The outcome of this, however, is not inevitable. A company can endure a lousy year without spending too much on payouts, and sometimes it is in their interest to do so. Hence, it is essential to keep in mind the company’s future earnings expectations and calculate a forward-looking payout ratio. Having a comprehensive overview will help to contextualize the company’s backward-looking one. Long-term trends are also vital when it comes to payout ratio. A payout ratio that is steadily rising could indicate a healthy and maturing business. However, a rate that is spiking could signify that the dividend is entering the unsustainable territory.
When it comes to the relationship between the retention ratio and dividend payout ratio, they are converse to one another, as shown by the payout ratio formula. The dividend payout ratio evaluates the percentage of profits earned a company pays out to its shareholders. On the other hand, the retention ratio represents the percentage of profits earned, either retained or reinvested.
Dividend Yield vs Dividend Ratio
Dividend Yield and Dividend Payout are two separate measures of dividends. It is vital to know the difference between the two. Dividend yield reveals the simple return rate, which is seen in cash dividend payouts to shareholders. On the other hand, the dividend payout rate represents the company’s net earnings, most of whom should be paid out as dividends.
While the dividend yield is the more popular term between the two, many believe that the dividend payout ratio is a better indicator of a company’s ability to distribute their dividends consistently in the future. The fact of the matter is that dividend payout is highly connected to a company’s cash flow.