Payout ratio definition
/What is the Payout Ratio?
The payout ratio is the proportion of dividends that a company pays to investors in relation to its reported net income. It is expressed as a percentage of the firm’s reported earnings. This is an essential financial metric used by investors to assess the ability of a business to pay dividends. It is especially useful when tracked on a trend line, to see if an organization is reaching an unsustainable level of dividend payments that will likely need to be curtailed in the future.
Understanding the Payout Ratio
A high payout ratio indicates that the company's board of directors is essentially handing over all profits to investors, which indicates that there does not appear to be a better internal use for the funds. This a strong indication that a business is no longer operating in any growth markets. An upward trend indicates that the cash flows of the business are increasing, which makes it easier for the company to support more payouts. From the perspective of an investor, the ratio should be either steady or upward-trending. Otherwise, those investors attracted to the stock because of its formerly reliable dividends will sell their shares, resulting in a reduction in the company's stock price.
A low payout ratio indicates that the board is more concerned with the reinvestment of funds in the business, with the assumption being that investors will instead generate a return through the appreciation of their shares on the market. A downward trend in the ratio can indicate that the cash flows of the business are declining, so that less cash is available for dividends.
An organization that does business in a highly competitive market will likely experience such variable earnings that the only prudent dividend policy is to keep the baseline dividend fairly low. At a higher level of dividend payouts, it will sometimes need to scale back its dividends to align its cash reserves with the variations in its cash flows. This means that a low payout ratio is caused by variable financial results, rather than any sort of decline in the firm’s long-term prospects.
A payout ratio of greater than 1:1 is not sustainable, and will eventually lead to a dangerous decline in the cash reserves of the business. One exception is when non-cash expenses, such as depreciation and amortization, are driving down net income below the amount of cash flows that are actually being generated. Another exception is when management is deliberately running down the business, with a plan to eventually close its doors. In this case, the final few dividends could greatly exceed reported earnings, as management distributes all residual cash to the shareholders. A third exception is when a business suffers a temporary decline in its cash flow that it expects to recover from in the near future, and so elects to maintain its normal dividend in the interim, to keep shareholders happy.
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How to Calculate the Payout Ratio
The calculation of the payout ratio is to divide the amount of dividends paid per share by the amount of net earnings per share, for which the formula is as follows:
Dividend per share ÷ Earnings per share = Payout ratio
Payout Ratio Example
As an example of the payout ratio, Nefarious Enterprises reports earnings per share of $10, and pays an annual dividend of $7 per share. This results in a payout ratio of 70% (calculated as $7 dividend per share divided by $10 earnings per share). In the following year, Nefarious reports the same earnings, but now the dividend is $12 per share, resulting in a 120% payout ratio. In the latter case, the payout ratio is not sustainable, for the company will eventually run out of cash if it keeps paying dividends at this rate.
The Ideal Payout Ratio
There is no perfect payout ratio. The proportion of earnings paid out as dividends will depend on the variability of earnings, as well as management’s perception of whether it makes better sense to use available funds to expand the business. Also, if the owners decide to shut down a business, then company management will collect all outstanding receivables, sell off assets, terminate staff, and issue quite a large dividend to the shareholders as part of the winding up process. In short, a business may justifiably have a very high payout ratio, or a very low one.
Problems with the Payout Ratio
There are several potential problems with the payout ratio, which are as follows:
Unreliable when earnings are volatile. Earnings can be highly volatile, which makes the payout ratio an unreliable measure. For example, if earnings drop temporarily, the payout ratio can appear artificially high, even if the company maintains a consistent dividend.
Ignores non-cash items. The ratio is based on net income, which includes non-cash items like depreciation and amortization. These may not accurately reflect the company’s ability to generate cash for dividends.
Excludes retained earnings usage. Companies may use retained earnings or reserves to pay dividends, which is not reflected in the payout ratio. This can make the ratio misleading.
Industry comparability issues. Different industries have varying norms for dividend payouts. Comparing payout ratios across sectors can lead to misinterpretations.
Overlooks growth stage. Younger, growing companies often reinvest earnings rather than pay dividends, leading to a low or zero payout ratio. Conversely, mature companies with limited growth opportunities might have a higher payout ratio.
Potential for misuse by management. Management may artificially reduce the payout ratio by retaining more earnings to fund expansion projects or executive compensation, rather than for valid strategic reasons.
By considering these limitations, analysts often supplement the payout ratio with other metrics, such as free cash flow, dividend coverage ratio, and earnings quality to gain a more comprehensive understanding of a company's dividend-paying ability.
Terms Similar to Payout Ratio
The payout ratio is also known as the dividend payout ratio.