What is the Dividend Payout Ratio?
The dividend payout ratio is a financial metric that shows how much of a company’s earnings are distributed to shareholders as dividends. This ratio is particularly important for dividend investors because it helps to show whether the company can continue to pay and grow its dividends.
It’s better for a dividend stock to have a low payout ratio because it shows that the company only pays a small portion of its earnings as dividends. This means the company pays less of its earnings as dividends and has more financial safety. A high payout ratio might become risky over time because it indicates that a significant portion of a company’s earnings are paid to shareholders as dividends, which might become unsustainable over time.
How Do You Calculate the Payout Ratio?
TIKR reports a company’s payout ratio, so you never need to calculate this ratio by hand:
But, it’s still important to understand how the formula works. The payout ratio divides a company’s dividend payments by net income to find what percentage of earnings are paid out as dividends.
Dividend Payout Ratio = (Common Dividends Paid / Net Income) x 100
Using Caterpillar’s (CAT) data:
- Last 12 Months (LTM) Common Dividends Paid: $2,608 million
- Last 12 Months (LTM) Net Income: $11,007 million
Dividend Payout Ratio = (2,608 / 11,007) × 100
Dividend Payout Ratio = 23.7%
This means Caterpillar distributes 23.7% of its earnings to shareholders as dividends while retaining the remaining 76.3% of earnings for other uses, such as reinvesting in the business or share buybacks.
Per Share Method:
Alternatively, investors can calculate the dividend payout ratio using the company’s dividends per share and earnings per share figures. This isn’t always as accurate, but it can be a more straightforward formula for investors use:
Dividend Payout Ratio = (Dividends per Share / Earnings per Share) x 100
In some cases, this formula may even yield a slightly inaccu:rate result because you have to verify that you are using basic LTM EPS and LTM dividends. Many stock analysis sites will report basic, diluted, LTM, and NTM (next twelve months) expected EPS, which adds a layer of confusion for investors.
Let’s use Caterpillar (CAT) as an example. Using Caterpillar’s data:
- LTM Dividends per Share (DPS): $5.31
- LTM Earnings per Share (EPS): $22.07
You’d calculate the dividend payout ratio like this:
Dividend Payout Ratio = (5.31 / 22.07) × 100
Dividend Payout Ratio = 24%
What Does the Payout Ratio Mean?
For long-term investors, a company’s dividend payout ratio can reveal more about a company’s dividend policy and overall financial health:
- Sustainability of Dividends: A reasonable payout ratio indicates that the company balances returning capital to shareholders with the need to reinvest in the business. A very high ratio (close to or above 90%) might signal that the company is over-distributing its earnings, which could lead to dividend cuts in the future if earnings decline.
- Growth Potential: Companies with lower payout ratios typically reinvest more of their earnings back into the business, which can be beneficial for driving long-term growth.
What is a Good Payout Ratio?
General Guidelines:
A “good” payout ratio can vary depending on context, but here are some general guidelines:
- Payout ratio below 70% signals strength: A payout ratio below 70% indicates that the company can comfortably make its dividend payments and still has enough earnings left over to reinvest in growth or to cushion against future downturns.
- Payout ratio between 70 and 90% raises some concerns: A payout ratio in this range is generally considered safe but could raise some concerns. While the company can make its dividend payments, it is paying out a higher percentage of its earnings, which means there is less room to maneuver if earnings decline.
- Payout ratio above 90% signals a high risk of dividend cuts: A payout ratio above 90% is concerning. It suggests that the dividend is at risk of being cut because the company is paying out such a high percentage of its earnings as dividends. The company might resort to raising equity or issuing debt financing to continue paying its dividend, which are both unsustainable.
Other Considerations:
Determining a “good” payout ratio also depends on the company’s industry and growth stage. Investors should consider their own investment objectives to select companies that will help them reach their investment goals:
- For Mature Companies: In established industries like utilities or consumer staples, a payout ratio between 50% and 70% is often considered healthy. These companies typically have stable earnings and generate enough cash flow to support higher dividend payouts without compromising their ability to grow.
- For Growth-Oriented Companies: In contrast, companies in growth industries such as tech or biotech might have lower payout ratios, often below 30%. These firms usually prefer to reinvest most of their earnings to fuel growth, research, and development.
- For Long-Term Dividend Investors: A payout ratio of around 30 to 70% is often ideal, as the company returns capital to shareholders through dividend payments while retaining enough earnings to invest in future growth.
Why is a High Payout Ratio Bad?
A payout ratio that consistently exceeds 90% is a red flag for investors. This ratio means that the company is paying out nearly all of its earnings as dividends, which is a big problem:
- Limited Reinvestment in Growth: A high payout ratio leaves the company with little funds to reinvest in growth opportunities such as new projects, R&D, or acquisitions. This can limit the company’s ability to expand and compete long-term.
- Increased Risk of Dividend Cuts: If a company’s earnings decline, or it faces financial difficulties, a high payout ratio leaves little cushion for maintaining dividend payments. This can lead to dividend cuts, often resulting in a loss of investor confidence and a drop in stock price.
- Financial Instability: To maintain high dividend payouts, a company may need to take on debt, which increases its financial leverage and risk. Over time, this can strain the company’s financial health and make it more vulnerable to economic downturns or interest rate hikes.
Payout Ratios for REITs
Real Estate Investment Trusts (REITs) are a special case when it comes to payout ratios. A REIT is a special type of publicly-traded company that owns, operates, or finances income-producing real estate. By law, REITs must distribute at least 90% of their taxable income to shareholders as dividends. This requirement often results in REITs having net income payout ratios that exceed 100%.
It’s better to use the FFO Payout Ratio for REITs to determine whether REITs have strong financial safety, because a REIT’s funds from operations is a better measure of a REIT’s underlying profit from properties than net income.
While high payout ratios are typical for REITs, investors should still evaluate the underlying cash flows, debt levels, and the quality of the properties in a REIT’s portfolio. These factors determine the sustainability of dividend payments.
How Are the Dividend Yield and Payout Ratio Related?
A stock generally has to increase its payout ratio to increase the dividend yield it offers to shareholders. Together, these measures provide a fuller picture of a company’s dividend policy:
- Dividend Yield: This ratio measures the annual dividends to shareholders relative to the stock’s current price. The dividend yield is useful for understanding the return on investment investors make from dividends alone.
- Dividend Payout Ratio: As discussed, the payout ratio indicates the percentage of a company’s earnings that are paid out as dividends. While the dividend yield focuses on the income return relative to the share price, the payout ratio assesses the company’s earnings sustainability.
Example:
Caterpillar (CAT) has a dividend yield of 1.5% and a payout ratio of 23.7%. This means that investors receive a 1.5% return from dividends, while the company only uses 23.7% of its earnings to pay those dividends. This indicates that Caterpillar has a strong capacity to sustain and continue to grow its dividend over time.
Investor FAQs:
Can the payout ratio exceed 100%?
The payout ratio can exceed 100% if a company pays more in dividends than it earns in net income. This sometimes happens if a company sees a temporary decline in earnings or if a company has been growing dividends in an unsustainable way.
Is a lower payout ratio always better?
It’s usually better to see a company with a lower payout ratio because that means the company’s earnings support its dividend payments. However, that also means the company is paying less of its earnings out as dividends, which might not be what dividend investors are hoping for.
How does the payout ratio impact a stock’s valuation?
The payout ratio can affect a company’s stock valuation by signaling the company’s approach to balancing growth and income. Consistent and reasonable ratios may attract income-focused investors.
Can a company have a negative payout ratio?
A company can have a negative payout ratio if its net income is negative (a loss) but still pays dividends, which is rare and typically unsustainable.
What’s the difference between the payout ratio and the retention ratio?
The payout ratio measures the portion of earnings paid out as dividends, while the retention ratio shows the portion of earnings retained by the company for reinvestment. They are complementary metrics.
TIKR Takeaway
The dividend payout ratio helps stock market investors to assess the sustainability and attractiveness of a stock’s dividends.
A lower payout ratio below 70% often indicates that the company has more room to reinvest in its business while still paying dividends to shareholders.
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Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold positions in any of the stocks mentioned in this article. Thank you for reading, and happy investing!
