The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends. The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so. A public company in a mature industry, or one whose sales are no longer growing rapidly, usually has a high dividend payout ratio. Such companies tend to attract investors who buy shares almost exclusively for the reliability of dividend payments; growth investors do not invest in these companies.
Newer companies that are using all of their cash flow to sustain a high rate of growth usually have a zero dividend payout ratio, and attract growth investors who are not concerned with dividends, but prefer instead to earn a profit on the appreciation of their shares in the business.
The ratio also reveals whether a company can sustain its current level of dividend payouts. If the ratio is greater than 100%, then the company is dipping into its cash reserves to pay dividends. This situation is not sustainable, and may result in the eventual termination of all dividends or the financial decline of the business.
It is also useful to examine the inverse of the ratio, which reveals how much cash the company is retaining for its own uses. If the retention amount is declining, this indicates that the company does not see a sufficient return on investment to be worthy of plowing additional cash back into the business.
There are two ways to calculate the dividend payout ratio; each one results in the same outcome. One version is to divide total dividends paid by net income. The calculation is:
Total dividends paid ÷ Net income
The alternative version essentially calculates the same information, but at the individual share level. The formula is to divide total dividend payments over the course of a year on a per share basis by earnings per share for the same period. The calculation is:
Annual dividend paid per share ÷ Earnings per share
For example, the Conemaugh Cell Phone Company paid out $1,000,000 in dividends to its common shareholders in the last year. In the same time period, the company earned $2,500,000 in net income. The dividend payout ratio is:
$1,000,000 Dividends paid ÷ $2,500,000 Net income
= 40% Dividend payout ratio
Be sure to track the dividend payout ratio over multiple years, so that you can spot any trends in the ability of the company to pay dividends. Trend analysis will also likely reveal the points when a company's board of directors decides to change the amount of dividends paid, which may also trigger a change in the types of investors who own the company's stock.
The dividend payout ratio is also known as dividend cover.