A company’s dividend payout ratio is a key performance metric. How you can calculate it and what is a good dividend payout ratio? Is a payout above 100% good or bad?
The dividend ratio defines the profit amount distributed as dividends out of the total earnings. Investors consider the payout ratio as a key performance metric. It provides useful information to investors about the company’s dividend policy.
As the dividend payout ratio directly relates profits with income distributed among investors, it can be used as a good measure of return on investment. As dividends are industry-specific, a payout ratio cannot be judged in absolute terms.
Let us help you understand the payout ratio and answer a commonly asked question by many investors; what if the dividend payout ratio is above 100%?
What is a Dividend Payout Ratio (DPR)?
A dividend payout ratio (DPR) is the amount paid to shareholders out of the total income generated by the company. It is denoted in percentage terms. It measures the relationship between the total income generated by the company and the income distributed among the shareholders.
A DPR also tells us about the retention rate of the company. A company uses profits as retained earnings or pays them in the form of dividends. Thus, a DPR also provides insights into the retention rate of a company. Investors can utilize the DPR and retention ratio to analyze the company’s financial plans.
A dividend payout ratio tells us about the financial strengths of a company. It also points out the investment and growth needs of a company. For instance, a company with a high growth rate would retain all or most of its earnings. Thus, its DPR will be zero or very low. Contrarily, an established company will look to distribute more among its shareholders as it has fewer expansion needs.
Dividend stocks need to sustain dividend growth as well. A consistent and growing DPR means a positive signal for the stock market. Investors also prefer stocks that follow a steady growth in dividend payments.
In a nutshell, a DPR offers valuable insights into a company’s earnings, retained earnings, dividend policy, sustainability, and growth prospects.
We can calculate the dividend payout ratio with the following formulas.
Dividend Payout Ratio = Dividend Per Share/Earnings Per Share
Dividend Payout Ratio = Total Dividend/Total Income
Or alternatively, if you know the retention ratio, it can be calculated as:
Dividend Payout Ratio = 1 – Retention Ratio
The dividend payout ratio is always expressed in percentage terms. The retention ratio defines the retained earnings of a company out of the total earnings.
Let us consider a simple example to understand the DPR.
Suppose a company ABC has a share price of $60. It announces a dividend of 20% per share ($ 1.20 per share). The company has a total outstanding number of shares of 1 million. It reported a total net income of $ 3 million. Thus, its EPS is $ 3 per share.
We can calculate its DPR as:
Dividend Payout Ratio = DPS/EPS
Dividend Payout Ratio = (1.20/3.0) × 100
Dividend Payout Ratio = 40%
It means the company paid 40% of its total income as dividends and retained the rest of 60%.
What is a Good Dividend Payout Ratio?
Some industries have to pay large dividends to their shareholders. For example, master limited partnerships (MLPs) and Real Estate Investment Trusts (REITs) have high dividend payout ratios. Such companies pay high dividends due to compliance requirements.
Established companies with large accumulated cash reserves and profits will always show higher dividends. It does not mean a low payout ratio is always bad. Companies in the growth stage would always reinvest the profits to fund projects.
Dividends are industry-specific. It means certain industries will pay higher dividends than others. Thus, a dividend payout ratio will always be different in a certain industry than in others.
For example, it is common to find a payout ratio of 100% – 200% within the REITs. Such a high dividend ratio is unlikely to be seen in other industries.
Growth Stage Companies
Companies in the early and growth stages will always reinvest profits. It means their retention rate will be higher and the payout ratio will be lower or even zero. However, investors can take advantage of the share price appreciation of these stocks.
Companies with established working history and accumulated profits will keep a consistent payout ratio. For several reasons, these companies maintain their payout ratio even if they incur losses occasionally.
A high dividend also doesn’t always offer a positive signal. Sometimes, it means a company does not have positive NPV projects to invest in.
Dividend growth is an important factor when evaluating the payout ratio. A company may keep a consistent payout ratio that still could fall short of the inflation rate. Thus, investors value dividend growth as much as the payout ratio.
Maintaining a dividend growth rate is difficult for many companies than offering a one-off high dividend.
A dividend payout ratio is best defined when used in benchmarking. A payout ratio alone in absolute terms cannot offer the full information. Investors can analyze the payout ratio with historic or industry benchmarking. For instance, to see if the company has maintained a consistent payout ratio increased, or decreased it over the past few years.
What If the Dividend Payout Ratio is Above 100%?
In simple terms, a payout ratio above 100% means a company is doling out more in dividends than it is earning. It should concern shareholders as much as it concerns the management. A company can never sustain such a high payout ratio.
Companies in different sectors would keep a different payout ratio. A company’s lifecycle will also dominate the dividend decision.
We can broadly categorize the dividend payout ratio into four categories.
Normal Payout Ratio
Companies in their early stages usually do not pay dividends. Some companies making large profits can offer dividends too. A dividend payout ratio of 0% to 30% is observed with these companies. As dividends are inconsistent with these companies, income-oriented investors do not value such dividends as much.
Healthy Payout Ratio
A dividend payout ratio of 30%-50% is considered a healthy payout ratio. Established companies with accumulated cash reserves would maintain such healthy payout ratios. A payout ratio of 50% means a company is payout half of its earnings as dividends.
Similarly, companies that pay dividends in the range of 50% to 80% are considered high payout ratios. Such a high dividend ratio is possible only for well-established companies that have low reinvestment requirements.
Excessive Payout Ratio
A payout ratio of 80% to 100% is considered very high. Anything above 100% is deemed to be excessive. It means a company is paying out in dividends more than it is earning. Thus, it will be difficult to maintain such excessive payout ratios. Investors must keep aware of these risks.
Risky Payout Ratio
Unless a company is taking advantage of accounting standards’ relaxation, maintaining a payout ratio above 150% is impossible. Such risky payout ratios are bad for investors and the company itself. In short, it means a company is borrowing to pay dividends which cannot be sustained in the long run.
A dividend payout ratio is a useful financial ratio for investors. Analyzing a good payout ratio requires looking at a broader context. A payout ratio above 100% is always considered risky. It is difficult to sustain unless a company has large accumulated cash reserves.