Every publicly traded company faces a decision when it prepares its periodic earnings reports: what to do with the earnings? Keep them to reinvest in the business? Or reward shareholders by passing along earnings in the form of dividends?
Companies try to strike a balance between the need to retain earnings for maintaining or expanding operations, and the need to give something back to shareholders, who are the collective owners of the company. This balance can be represented by a company’s dividend payout ratio.
What is the dividend payout ratio?
The dividend payout ratio is that proportion of earnings a company decides to pay shareholders as dividends. The proportion it retains is called the retention ratio. Each ratio is expressed as a percentage, and together they add up to 100% of a company’s net income. Dividends are typically paid in cash, although sometimes there are other forms of payment.
Here’s a simple illustration: A company reports $1 million in quarterly earnings and the board of directors approves $250,000 as a dividend payment. This means the dividend payout ratio is 25%, or $250,000 divided by $1,000,000. The other $750,000 is retained, for a 75% retention ratio.
Why the ratio matters to investors
Payout ratios can vary based on a wide range of factors, and investors consider them (and retention ratios) when deciding which kinds of companies to own. Companies can be classified based on whether they have a high or low payout ratio.
A high payout ratio indicates that a relatively high share of earnings flow to investors as dividends. Older, well-established companies tend to make bigger dividend payouts. They have already achieved growth, and they often have a large market share in their businesses, which generate reliable earnings and cash flow. They generally need to retain less of their earnings for reinvestment or expansion. Examples include Coca-Cola, with a payout ratio of about 80%; Procter & Gamble, at 60%; and Verizon, at 48%.
A low ratio generally means a company wants retained earnings to reinvest for aggressive growth and reward investors through a higher stock price. Some examples of lower-payout companies include Apple, with a ratio of about 15%; and Microsoft, at 26%.
Companies that are unprofitable or don’t pay dividends won’t have a payout ratio. Among the biggest companies with no dividends are Alphabet (Google), Amazon, Netflix, and Tesla.
The average payout ratio among S&P 500 companies was 28.2% in 2021, the lowest in a decade because earnings grew faster than dividends. Payout ratios tend to increase during economic slowdowns as companies maintain dividends even with declining earnings; the ratios tend to decrease during expansions when earnings gains outpace dividend growth.
How to calculate a payout ratio
There are a few ways to calculate a payout ratio, some of them more complicated than others. The simplest and handiest is to divide per-share dividends by per-share earnings (or net income divided by the number of shares outstanding). Annual per-share numbers are generally used, and are readily available from various public sources. Imagine a company, ABC Corp., with annual profit of $4.50 a share and dividends of $1.50 a share. The calculation for the payout ratio is:$1.50 dividends/$4.50 earnings = 0.33 or 33%Investors also can estimate future dividends by applying the ratio to a forecast of per-share earnings, assuming the company maintains a steady dividend policy. So if the forecast for ABC earnings next year is, let’s say, $5.25 a share, and the payout ratio is 33%, estimated dividends in the coming year would be: $5.25 X 0.33 = $1.73 per share
What is a good payout ratio?
There is no good or bad payout ratio, per se. It may depend on trends in the industry or a company’s particular circumstances. Companies that are organized as partnerships or trusts, for instance energy master limited partnerships and real estate investment trusts (REITs), are required by law to pay out almost all of their earnings to shareholders.
Sustainability of payouts is key. Apple is a good example. The company resumed paying dividends in 2012, after a 17-year interruption. It has steadily increased the dividend since then, yet the payout ratio is only about 15%, giving the world’s most valuable company by market value ample room to continue paying dividends and have plenty left for reinvestment in the business.
Investors consider several things when evaluating a payout ratio:
- The age and maturity of a company, and its industry. Maturity refers to the stage of a company’s life. Younger companies are often in industries such as biotechnology, digital finance and e-commerce, and tend to have low payouts or no payouts. Older companies include Coca-Cola, IBM, and 3M.
- The company’s financial condition. Has it had recent successes, or setbacks? Is it gaining or losing market share in its industry?
- Payout ratio history. Investors may ask: Is the payout consistent? Is the ratio relatively low with room to grow, or is it already high? Or is a high payout ratio a warning sign for a later dividend cut?
When is a ratio too high?
A red flag is when a company is paying more in dividends than it makes in profit (a 100% or higher payout ratio). Market professionals consider this an unsustainable dividend.
General Electric, Boeing, and automakers General Motors and Ford are among notable companies that were forced to cut or suspend dividend payments in recent years. Boeing and the automakers stopped dividend payments in early 2020 with the onset of the Covid pandemic, and GE was undergoing an extensive reorganization that included spinning off several businesses into separate companies. It reduced its payout to 1 cent a share, or 8 cents after a 1-for-8 reverse stock split. In December 2021, Ford resumed its dividend payment.
Funds and dividend payouts
Investors also can get dividends indirectly from mutual funds (as well as index funds and exchange-traded funds) that have dividend-paying stocks among their holdings. Funds are required to pass along any dividends to their holders, at least once a year.
Investors may take the dividends in cash or reinvest them in the fund. Reinvestment is an attractive option if the investor has an individual retirement account (IRA), 401(k) or other tax-advantaged retirement account. Otherwise, dividends are taxable, either as ordinary income or as capital gains, depending on circumstances.
Dividend payout ratio vs. dividend yield
Dividend yield is the amount of dividend income a stock investment generates, expressed as a percentage of the price of a share. So if ABC Corp.’s annual dividend is $1.50 per share and its shares are trading at $45, the dividend yield is:
$1.50/$45 = 0.033 or 3.3%
Another way to think of this: For every $1 invested in the shares of ABC, an investor buying at $45 earns a return of 3.3 cents a year.
Dividend yield fluctuates with the share price, and a company has no direct control over the dividend yield.
Payout ratio, by contrast, is determined by the company, not the markets. It is driven by the company’s earnings and the management’s strategy and planning, and its decisions about keeping or sharing the earnings.
The bottom line
Dividend payout ratios may get less attention than dividend yields, but they can offer more fundamental information to investors such as a company’s financial strength, its life-cycle stage, and its strategy for use of earnings and cash flow. These are key considerations for investors in screening stocks for income potential from dividends, growth potential and capital gains from higher stock prices.If you’re ready to start growing your capital, Titan is ready for you. Our team of exceptional investment analysts manage hundreds of millions of dollars, investing our clients in actively-managed, long-term strategies with an eye on massive growth potential. Through our award-winning app, you’ll ride shotgun with some of the smartest investment minds in the business. Sign-up takes minutes: get started today.