The dividend payout ratio, often referred to as the “payout ratio,” calculates the total amount of dividends paid out to shareholders relative to the company’s net income. The money not paid out to shareholders is used by the company to reinvest, pay off debts, or be added to cash reserves.
Essentially, the dividend payout ratio shows how much money a company is returning to its shareholders and how much they are keeping.
How to Calculate Dividend Payout Ratio
The formula for dividend payout ratio is as follows:
Dividend Payout Ratio = Dividends Paid ⁄ Net Income
Dividend Payout Ratio = 1 – Retention Ratio
What Does the Payout Ratio Mean?
If a company’s payout ratio is 0%, then it does not pay dividends. If the payout ratio is 100%, the company pays out its entire net income as dividends.
In some circumstances, a company’s payout ratio is over 100%, which means it is paying out more money to shareholders than it earns. This could lead to the company lowering the dividend or stop paying the dividend altogether. Cutting dividends can cause the stock price to drop, with shareholders viewing the lack of dividends as an indication of poor management.
A long-term, steadily rising payout ratio can suggest a healthy company, whereas a spiking one could indicate that the dividend is unsustainable.
Interpreting Payout Ratio
The maturity of a company is an important factor when interpreting the payout ratio. The newer a company is, the more it will be aiming to grow. When a company wants to grow, a 0% payout ratio can be validated — as they want to put more money into development rather than dividends. Equally, a more mature company may have less ambition to grow or move into new markets, so a higher payout ratio can be expected.
Dividends are very industry specific, so it is important to research the industry standard. Real estate investment trusts (REITs) have a very high payout ratio, as they are legally obligated to give out 90% of earnings to shareholders. This is because they enjoy tax exemptions.
Payout ratio is often confused with dividend yield. The latter expresses how much a company pays in dividends each year relative to its stock price — rather than relative to its net income.