When investing in a company’s stock, you become an owner of a share of that company—a shareholder, if you will. And as a shareholder, we think it’s safe to assume that you’d look forward to receiving a piece of the company’s profits. For current and potential shareholders, one of the most important metrics to factor in your investment decisions is a corporation’s dividend payout ratio.
What is the dividend payout ratio?
The dividend payout ratio is basically the percentage of a company’s net income that is redistributed to shareholders in the form of dividends at the end of each period or year, compared to how much of its earnings is retained to reinvest toward growth, pay toward debt, or simply add to cash reserves.
This metric is sometimes referred to as simply the payout ratio, and can easily be derived from the total dividends and net income of any company, which should be readily found in its financial statements.
This rather straightforward equation can be expressed mathematically as:
Total dividends / net income = dividend payout ratio
For example, Company A reported a net income of $1,000 while only distributing $400 as dividends to shareholders. This results in a 40% dividend payout ratio, which can be considered a “healthy” percentage by analysts (between 35% and 55%), although there really isn’t an “ideal” payout rate because all companies (and industries) are built differently.
Do all companies pay out dividends?
There are instances when management might decide to retain more earnings for the next period’s spending or investment budget. This is especially true for startups and high-growth industries, like technology.
In fact, Apple, a company incorporated in 1977 and famous for having twice as much cash on-hand than the US government, paid out its first dividend in 17 years back in 2012.
In this sense, the dividend payout ratio can also be seen more as the portion of a company’s net income that is retained to fund the company’s operations, innovations, investments, and expansion (or debt payments). This is generally acceptable to shareholders, who may favor passing on dividends, if the actual value of their stock continues to show strong growth (capital gains).
Read also: Use dividend yield to make wiser investment decisions
On the other hand, well-established companies or those in mature industries are more likely to pay out a higher dividend on a more consistent basis, perhaps due to having less room for additional growth and investment. So as you can see, whether a company pays out high or low dividends (or even at all) does not necessarily indicate that it is performing well or poorly.
In the end, it all depends on what its investment and business goals are, and how company earnings are directed toward achieving them.
What does the dividend payout ratio tell me?
Despite what the previous section explains, the dividend payout ratio is still very important because investors see steady and sustainable dividends as good indicators of a healthy company. This means that a company that suddenly has a dividend payout ratio of 50% for one year after not distributing any dividends in the last 5 years is generally not as attractive an investment as a company that has consistently maintained a 20% dividend payout ratio for the last decade.
Companies know this, and are motivated to pay sustainable dividends, even if it means paying a steady dividend on a one-off bad year that results in a dividend payout ratio of more than 100%. Paying out unusually high dividends can also be a strategy to spur interest, attract investors or increase stock value.
Just be wary that the company might not be able to sustain dividends at this level, and may even run out of money to continue operations. Remember that it’s also important to evaluate and properly weigh the long term value of holding a stock against potential gains (or losses) in the short term.
Conversely, companies are also hesitant to cut or decrease dividend payouts, as this can lead to loss of confidence from upset shareholders and a resulting decrease in stock price due to the perception of poor management. There is always a thin line that companies tread between achieving operational success and maintaining shareholder confidence.
As investors, it is always important to view a company’s dividend payout ratio in the right context.
The bottom line
The dividend payout ratio is a useful metric that will help you understand how a company is performing, provide insight into what stage of maturity or growth it is in, and even clue you in on the operational strategies that it seeks to implement.
Although, different investors will evaluate the dividend payout ratio in different ways:
- Those seeking a steady passive income will look for a higher dividend payout ratio, which would usually be offered by well-established companies in mature industries
- Those looking more toward capital gains (an increase in stock value) might forgo high DPR, especially in new companies in growth industries, like technology
When evaluating a company by its dividend payout ratio, it is important to put it in the context of its level of maturity, its industry, its operational needs, and it’s strategic goals (among many other things).
What does hold true, in almost all cases, is that trends and consistency over time can mean a lot in terms of showing stability and keeping investors happy:
- A company that may have a low, but growing dividend payout ratio can be in the development stage and show promise for higher dividend payouts in the future
- A company that has steadily been reporting a lower dividend payout ratio over time raises a few red flags, unless sufficiently justified by management
In the end, it is your own risk tolerance and personal experience that might lead you to favor a consistent over a high dividend payout ratio (or vice versa).
We encourage you to take the time to evaluate a company’s overall investment outlook through proper research and using additional tools and metrics (like the Rule of 72) that we discuss in other articles, right here in Academy.
