It always feels good to see dividend payments hit your brokerage account. It’s great to have some of your capital returned to you without having to sell your stock.
Dividends can do wonders for your emotionally psyche.
But how do you know if the company is in danger of cutting the dividend?
Or that the dividend payments are secured for years to come?
A savvy dividend investor knows that one indicator that helps determine the safety of your dividends is the payout ratio.
In this article, we go over what the dividend payout ratio is, how to calculate it, and then provide some basics about low and high payout ratio stocks.
- What is a Dividend Payout Ratio?
- Dividend Payout Extremes: What they Mean
- Dividend Payout Ratio vs Dividend Yield: Differences
- The Importance of Earnings on the Payout Ratio
- What does a High Dividend Payout Ratio vs a Low Payout Ratio Mean?
- High Dividend Payout Ratios
- Low Dividend Payout Ratios
- What does a Dividend Payout Ratio Over 100% mean?
- Payout Ratios as a Dividend Metric
- Dividend Payout Ratio Conclusion
- Dividend Payout Ratio FAQs
What is a Dividend Payout Ratio?
The dividend payout ratio measures the percentage of earnings that are paid out to shareholders as dividends by a company. Investors closely watch this number as it can give clues to the company’s dividend policy.
If a company had a payout ratio of 30% that means that for every $1.00 of earnings, they pay out $0.30 to their shareholders as dividends.
Dividend Payout Extremes: What they Mean
Payout ratios have a range from 0% to over 100%.
If a company’s dividend payout ratio is 0%, then that means the company does not pay a dividend to its shareholders. An investor then has to rely solely on capital appreciation (stock price increases) in order to make a profit.
If a company’s dividend payout ratio is 100% then every single cent of profit is being paid out to shareholders and the business cannot grow.
Look for companies that have grown dividends for approximately 10 years at the minimum. You can trust a dividend growth company that has a track record of paying a dividend over many years more than a company that just started paying a dividend.
There are two ways to calculate the dividend payout ratio. One method is to use earnings per share, and the other method is to use free cash flow per share.
1. Dividend Payout Ratio (DPR) Formula Based on Earnings
The dividend payout ratio uses annualized dividends.
Some financial websites quote dividends quarterly rather than annually. If the source uses quarterly dividend payments, then you need to add up the last four quarters’ worth of dividends to come up with the annual dividend figure.
Both of the formulas below mean the same thing.
DPR =Dividends per share (DPS) / Earnings per share (EPS)
Or if you are looking at entire company financials:
DPR = Total dividends paid / Net income
Dividend Payout Ratio (DPR) Example
If a company pays out $5,000 in total dividends and it has 2,500 shares outstanding, then the dividends per share is $2.00.
The profit a company makes is called “net income” at the company level and it is called “earnings per share” when you are referring to one share.
If the same company has a net income of $10,000 and it has 2,500 shares outstanding, then the earnings per share is $4.00.
1. Earnings Dividend Payout Ratio
The dividend payout ratio (DPR) = Dividends per share (DPS) / Earnings per share (EPS)
= $2.00/ $4.00 = 50%
The dividend payout ratio is 50% and the company pays $0.50 out of every dollar in profit to its shareholders.
Alternatively, if you have the net income and total dividends paid data in front of you can calculate the dividend payout ratio as
DPR = Total dividends paid / Net income
= $5,000/ $10,000 = 50%
It yields the same answer as above.
Dividends are one way a company can utilize its profits. Other uses are for:
- Repurchasing shares
- Keeping as retained earnings
- Paying down debts
- Buying assets
2. Free Cash Flow Dividend Payout Ratio
Earnings are affected by non-cash accounting charges such as depreciation and amortization, which rarely affect a company’s cash flow outside of the first year.
Therefore, even though earnings per share is commonly used, some investors feel a better method to calculate the dividend payout ratio is to use free cash flow. Free cash flow is the real cash profit.
Companies are required to put forth a Statement of Cash Flows every quarter to show how they are spending their cash. Strong cash flows are good for dividends, as a company pays dividends out from cash profit.
This is why some investors feel the dividend payout ratio should be based on free cash flow:
Free cash flow dividend payout ratio = Annual dividend per share / free cash flow per share
If a company has a free cash flow per share of $2.50 and pays a dividend of $1 then the free cash flow payout ratio is 40%.
The company can use the other 60% to improve the business.
Dividend Payout Ratio vs Dividend Yield: Differences
Remember that the dividend payout ratio is the percentage of company earnings that the shareholders receive as dividends. If Company XXS has a payout ratio of 55% then that means that they are paying the shareholders $0.55 out of every $1 of profit as dividends.
The dividend yield of a company is the dividend expressed as a percentage of the stock price. If a company XXS’s stock price is $100 and the dividend annually paid out is $3.00, then the dividend yield is 3/100 = 3%.
The dividend payout ratio and the dividend yield are percentages of two entirely different metrics.
The dividend payout ratio is a measure of the dividend paid out versus earnings.
The dividend yield is a metric that measures the dividend paid out versus the stock price.
The Importance of Earnings on the Payout Ratio
Keep in mind that earnings still have to fuel the company’s growth objectives as well, so that the company can continue rewarding its shareholders with dividends or share buybacks. It is essential for dividend investors that a company show appreciable increases in earnings each year.
A company needs to either increase revenues, cut costs, or do both, to drive up profits.
A company can only cut costs and expenditures for a while before they cannot cut anymore without significantly affecting the business. Therefore, the best way to increase earnings is through growing its revenue.
If you see the payout ratio run extremely high, the dividend may be in jeopardy. At the very least the dividend increases could slow down as the company is not earning enough profits to keep growing the dividend at a healthy rate.
A company’s dividend could be severely affected if there is a substantial decline in earnings and it has a high payout ratio.
A low payout ratio in the 20-30% range means that there is a lot of room for dividend growth in the future.
The payout ratio is important because it provides a good benchmark for dividend safety. The lower a company’s payout ratio, the more dividend safety there is, all other things being equal.
What does a High Dividend Payout Ratio vs a Low Payout Ratio Mean?
Look at the following three companies. Listed are the dividends and earnings per share of each company, along with the payout ratio. How do you interpret the results?
|Dividend Per Share ($)||2.00||12.00||18.00|
|Earnings Per Share ($)||20.00||20.00||20.00|
|Dividend Payout Ratio||10%||60%||90%|
Company A has a dividend payout ratio of 10% which is low. Company B has a payout ratio of 60% which is considered average and Company C has a very high payout ratio of 90% of earnings.
High Dividend Payout Ratios
Investors considered a high dividend payout ratio to be anything over 70%. Companies that dedicate most of their earnings to dividend payments are generally stable and mature companies. They are not growing exponentially, but they are blue-chip companies.
These companies make it a point to share their profits with shareholders. Investors who want income like the predictably of these dividend payments.
You should be cautious whenever a company has a very high payout ratio because any slight drop in earnings could cause a slowing dividend growth rate or a dividend cut.
Low Dividend Payout Ratios
A company with a low dividend payout ratio is still growing and therefore reinvests most of its profits back into its own business. Real-life low dividend payout ratio companies are Alimentation Couche-Tard (ATD) and Apple (AAPL).
Companies like these focus on returning value to the shareholders through stock price appreciation. Growth-oriented stocks try to run efficient businesses that become more attractive to investors because of the expectation of higher stock prices in the future.
When companies switch from their growth phase to a more mature phase, they may decide to become dividend payers. Over the next few years, they may choose to grow their dividends much faster than their earnings grow. They can achieve this because they are starting from a low base.
However, at a certain point in time, the dividend growth becomes unstainable and will have to slow down to match a company’s earnings growth rate.
If a company has earnings per share of $5 and just started paying a dividend of $1.00 per share, then the opening dividend payout ratio is 20%.
The table below shows how a company can have an exceptionally high dividend growth rate that outstrips the earnings per share growth rate for only a finite amount of time.
Suppose a former growth company now can only grow earnings by 7% per year. The company now wants to pay a dividend, as it is maturing.
The company wants to grow dividends by 20% per year, even though earnings are only growing by 7%. They will sustain it, as the table shows, but only for a finite amount of time.
|Dividend Per Share ($)||1.00||1.20||1.44||1.73||2.07||2.49||2.99||3.58||4.30||5.16|
|Earnings Per Share ($)||5.00||5.35||5.72||6.13||6.55||7.01||7.50||8.03||8.59||9.19|
The dividend payout ratio stays relatively low for a while and because of compounding, it increases quickly, reaching 56% in year 10.
At that point, the dividend growth rate needs to slow down to the level of the earnings growth rate to keep the payout ratio from skyrocketing too high.
So instead of a dividend growth rate of 20%, now the dividend policy would likely change to be 7% per year at a maximum.
What does a Dividend Payout Ratio Over 100% mean?
A dividend payout ratio over 100% means a company is paying out more than they are earning and they may have to use debt sources (loans) to keep paying a dividend.
Another way to think of this is that the company is losing money after it pays its owners their share of the profits, and that is not a sustainable business model.
Once a company uses debt to pay out dividends, then the interest payments on the loan reduce the company’s ability to increase profits the next year. It starts a negative cycle.
If earnings continue to slump, then the company would be a prime candidate for a dividend cut. A company cannot keep affording to pay a dividend that is more than their profit for a long time unless they have an extraordinarily huge cash position.
Payout Ratios as a Dividend Metric
When looking at dividend payout ratios, remember that one single metric should not make or break whether you invest in a particular company.
There are some who look at the Price-to-earnings ratio and decide if it’s higher than 20 times earnings, a company is too pricey.
That may be true based on current earnings but what if the company is set to unveil a revolutionary product that would increase earnings substantially? The current P/E ratio would not be able to account for that.
That is why the dividend payout ratio on its own cannot be a make or break metric. One ratio cannot tell the whole story of the company and address its total financial picture.
When looking at payout ratios ensure that you look at a 5-year or even a 10-year trend so you get an idea of what a “normal” payout ratio for the company looks like.
If you see a quarter or two with suspiciously high payout ratios over the normal historical ratio then you need to investigate why that jump occurred.
Make sure you compare the payout ratios between the company and their peers within the same sector. If you are looking at the telecommunications sector you would want to compare the key financial metrics between Bell (BCE.TO) and Telus (T.TO).
Dividend Payout Ratio Conclusion
Now that you know about the dividend payout ratio (DPR) be sure to analyze each company’s DPR to assess how safe its dividend is. After all, you don’t want to purchase a stock and then face a dividend cut in the next year or two because the payout ratio was too high.
What are some blue chip companies with very good dividend payout ratios in your eyes? Comment below so that everyone can debate whether these stocks should be on your dividend growth watchlist.
Dividend Payout Ratio FAQs
What is a good dividend payout ratio?
A good dividend payout ratio for non-REIT and utility companies is in the 30-60% range. At the lower end, it signals that the company is still growing but also willing to reward shareholders. At the high end, it signifies the company is shareholder-oriented, without over-extending itself.
What does a 100% dividend payout ratio mean?
A company that has a dividend payout ratio of 100% means that it is spending every dollar of profit on paying the dividend. This is not sustainable in the least, and any dip in earnings could result in a dividend cut.
Is a higher dividend payout ratio better?
A higher dividend payout ratio is generally good up to about 60-65%. A dividend payout ratio aboe that puts the company at risk for future dividend cuts or it may cause a slowing of the dividend growth. A company should retain some of its cash to expand its business, pay down debt or put in its cash account for a rainy day.
How do you analyze a dividend payout ratio?
The dividend payout ratio is calculated as the annual dividend per share divided by the annual earnings per share. If a company has an annual dividend of $1.00 per share and a earnings per share of $2.00 then the dividend payout ratio is 50%.
If you want to increase your dividend investing knowledge, here are some important articles to check out: