Dividend Payout Ratio

Calculating the dividend payout ratio

The dividend payout ratio is defined as the percentage of earnings paid to shareholders in dividends. Companies typically calculate dividend payout ratio on an annual basis in order to produce uniform results. Dividend payout ratios are calculated in two ways; one method is to divide the yearly dividends per share by the company’s earnings per share, as in:

• Yearly Dividends per Share / Earnings per Share = Dividend Payout Ratio

An alternate method is by dividing total dividends by the company’s net income, which can be expressed by the formula:

• Total Annual Dividends / Annual Net Income = Dividend Payout Ratio

These formulas derive the percentage of profit that a company returns to its shareholders as dividends. This information is useful in two ways; it indicates the extent to which profits justify the current payout ratio, dividend level, and dividend growth rate, and it also provides an estimate of the level of reinvestment the company is currently practicing.

Historic dividend payout ratios

Dividend payout ratios depend in part on the general economic conditions. For instance, throughout the 1980s, the overall dividends’ payout ratio average was 38.6%. In the 1990s, that ratio dropped to 23.2%. Historically, dividend payout ratios have decreased over time; in the 1940s, for instance, the average dividend payout ratio was 74.2%.

Dividend payout ratios typically increase over time and may exceed 100%

Most new companies have low dividend payout ratios due to the necessity for reinvestment of profits into the core business or debt reduction activity. As companies mature and gain financial stability, dividend payout ratios increase commensurately in most cases. Therefore, dividend payout ratios are generally a very rough indicator of financial health, since these ratios do not take into consideration the rate of reinvestment, debt reduction, or the maturity of the company’s business interests and investments. In some cases, dividend payout ratios may exceed 100%; this is usually not a sustainable situation. Unusually high dividend payout ratios may result from a one-time hit to net income, ongoing tax advantages from high payouts, or expected near-term growth in income that has not yet materialized.

Dividend cover

The inverse of the dividend payout ratio is the dividend cover; this ratio measures the amount of net income retained in the company rather than distributed as dividends. The dividend cover ratio is calculated by dividing the annual earnings per share by the annual dividend per share; the resulting figure is used to determine the company’s likely ability to continue to pay dividends to its shareholders. Ratios of 2 or higher are considered financially safe, since the company has more than enough profit to justify the dividend amount it is paying. Ratios under 1 are high-risk and generally indicate that the company is dipping into previous retained earnings in order to cover current dividend payments.

Both high and low dividend payout ratios have advantages for shareholders

Shareholders are generally in favor of high dividend payout ratios, since they put more money directly into their hands. However, in some cases investors prefer companies that offer lower dividend payments and practice a higher degree of reinvestment and consequent capital growth; since capital gains are taxed at a lower rate than dividend payments, this can offer significant tax benefits while increasing the overall value of shares in the company’s stock.
Tim Ord
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Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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