What is Dividend Payout Ratio?

Dividend payout ratios are like slicing a pie...

The company’s income is the pie, and the slice that you receive is the dividend that the company pays. The larger the dividend, the larger the slice that you receive. However, if you get a large slice, that leaves less for the company to eat until the next pie arrives from the bakery.

Dividend payout ratios are important because they show how much money a company returns to its shareholders as compared to the amount of money that the company keeps for itself. The more money that the company retains for itself, the more resources it will have available for investment or expansion.

Growing companies will often have a low dividend payout ratio or not pay a dividend at all — instead, they focus on using earnings to grow the business. Established companies, often called “blue chips,” are more likely to have high dividend payout ratios as they don’t need to fund aggressive growth.

If you’re a conservative investor, looking for companies with a history of high dividend payout ratios can be a good way to find more stable companies. If you want a higher risk, higher reward investment, focusing on companies with lower ratios, or no dividends at all, can help you find companies that are trying to increase growth.

Cash dividend payout ratio is a less commonly used ratio than the dividend payout ratio. It measures the relationship between a company’s dividends and its cash flow from operations, minus capital expenditures and preferred dividends.

The formula is:

Cash Dividend Payout Ratio = Common Stock Dividends Paid / (Cash Flow - Preferred Stock Dividends Paid - Capital Expenses)

For example, if a company produces $50 million in cash flow, pays $5 million in dividends to common shareholders, pays $1 million in dividends to preferred shareholders, and makes $20 million in capital expenditures, its cash dividend payout ratio will be: $5 million / ($50 million - $1 million - $20 million) = 17.24%

Proponents of the cash dividend payout ratio argue that it is a better ratio to use. One reason is that it is a more accurate indicator of whether a company can sustain its dividend payments. Companies will usually try very hard to maintain their dividends, as cutting dividends due to cash flow issues can cause investors to sell out of a stock.

The cash dividend payout ratio considers capital expenditures that ensure that the company can keep operating in the future. If the cash dividend payout ratio is too high, it indicates that a company is stretching itself thin to maintain its dividend. For example, a cash dividend ratio over 100% means the company is depleting savings to make payments. Anything above 85% is likely to be unsustainable unless things change.

Dividend payout ratio is a measure of a company’s dividend as compared to its earnings per share. Just as a price-to-earnings ratio compares a company’s earnings to its stock price, dividend yield measures a company’s dividend as compared to its stock price.

You can only calculate a company’s dividend payout ratio when it files financial reports that include information about its earnings per share and planned dividends. By contrast, a company’s dividend yield changes all the time. Every time the price of a stock changes, its dividend yield changes.

For example, on September 12, 2019, Coca-Cola closed at $55.30 and paid an annual dividend of $1.60. That means that its dividend yield was:

$1.60 / $55.30 = 2.89%

When the market closed on October 7, 2019, Coca-Cola closed at $53.87 and an annual dividend of $1.60. That makes its dividend yield:

$1.60 / $53.84 = 2.97%

Even though the dividend didn’t change, the change in price resulted in a change in the dividend yield.

Income-focused investors like to look at dividend yield because it shows what cash return they’ll earn on the money that they put into the investment based on the price of the stock when they buy it.

Dividend sustainability is a company’s ability to continue paying its dividend.

To think about it in simple terms, if a company pays $10 million in dividends every year, it needs to have at least $10 million in cash available to pay those dividends. Ideally, it will pay those dividends out of its profit rather than depleting its cash reserves. If the company doesn’t make $10 million each year in profit, something will have to give. Either the company will empty its bank account until it cannot afford the $10 million in dividends each year, or it will have to reduce its dividends to a more sustainable level.

A company’s dividend payout ratio and cash dividend payout ratio offer an excellent way to figure out whether a company’s dividend is sustainable. A ratio that is higher than 100% is a visible indicator that the dividend is unsustainable without a significant increase in the company’s revenue or profit. Lower ratios indicate a more sustainable dividend or even one that has the potential to grow.

Related to the concept of dividend sustainability is dividend growth. As companies grow and bring in more money, many will increase their dividends to return more cash to their shareholders. Well-established, blue-chip companies have built a reputation for consistently increasing the size of their dividends. For example, the S&P 500’s dividend aristocrats are the companies that are part of the index that have increased their dividend payouts for at least 25 years in a row. Many investors see that consistency as a sign of a stable company that will remain successful in the long term.

If a company hopes to join the ranks of dividend aristocrats or hopes to increase its dividends regularly, keeping its payouts sustainable is essential.

What qualifies as a good dividend payout ratio is different for every company and market sector.

Generally, younger companies that are focused on growth will want to have lower dividend payout ratios or not pay a dividend at all. Instead, they should use their money to invest in the company and grow. Some investors see dividends as a sign that the company has nothing better to do with money than to return it to investors. Growth-focused companies should be retaining more funds and have a lower dividend payout ratio.

More established businesses can have higher dividend payout ratios but need to find the sweet spot of high dividend payments and sustainability. Most investors consider ratios between 30% and 55% to be healthy. Not too high and not too low.

As the dividend payout ratio gets higher, it becomes more unsustainable. Ratios in the range of 55% to 70% indicate that a company isn’t focusing heavily on growth, which may affect its long-term success.

As the dividend payout ratio nears 100%, it means that the company is paying out most or all of its profit as dividends. This usually happens when companies don’t want to alarm investors by reducing dividends and is likely to be unsustainable without significant changes to the company.

If the dividend payout ratio exceeds 100%, that means that the company is paying out more money than it brings in, using cash reserves to cover the difference. A dividend of this size is unsustainable and a warning sign.

Similarly, dividend payout ratios of less than 0% are a huge warning sign. This can only happen when a company’s earnings per share are negative, which means that the company is losing money. Unless the company can find a way to turn things around and make a profit, there is no way for it to continue paying a dividend with a payout ratio below 0%.