What is the Dividend Payout Ratio?

The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends. The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so. A public company in a mature industry, or one whose sales are no longer growing rapidly, usually has a high dividend payout ratio. Such companies tend to attract investors who buy shares almost exclusively for the reliability of dividend payments. Conversely, growth investors do not invest in these companies.

How to Calculate the Dividend Payout Ratio

There are two ways to calculate the dividend payout ratio; each one results in the same outcome. One version is to divide total dividends paid by net income. The calculation is:

Total dividends paid ÷ Net income = Dividend payout ratio

The alternative version essentially calculates the same information, but at the individual share level. The formula is to divide total dividend payments over the course of a year on a per share basis by earnings per share for the same period. The calculation is:

Annual dividend paid per share ÷ Earnings per share = Dividend payout ratio

Example of the Dividend Payout Ratio

The Conemaugh Cell Phone Company paid out $1,000,000 in dividends to its common shareholders in the last year. In the same time period, the company earned $2,500,000 in net income. The dividend payout ratio is:

$1,000,000 Dividends paid ÷ $2,500,000 Net income = 40% Dividend payout ratio

Newer companies that are using all of their cash flow to sustain a high rate of growth usually have a zero dividend payout ratio, and attract growth investors who are not concerned with dividends, but prefer instead to earn a profit on the appreciation of their shares in the business. The ratio also reveals whether a company can sustain its current level of dividend payouts. If the ratio is greater than 100%, then the company is dipping into its cash reserves to pay dividends. This situation is not sustainable, and may result in the eventual termination of all dividends or the financial decline of the business.

Advantages of the Dividend Payout Ratio

Here are some of the main advantages of using the dividend payout ratio:

Indicator of financial stability. A consistent dividend payout ratio can signal financial stability and predictability. Companies with stable or growing dividends over time may be more financially stable and well-managed.
Insight into earnings quality. Companies that pay a low dividend payout ratio may be reinvesting profits back into the business to fuel growth, indicating they are in a growth phase. Conversely, companies with a high dividend payout ratio may have fewer growth opportunities or might be in a more mature stage, which can help investors assess the company’s growth potential.
Appeals to income investors. The dividend payout ratio is essential for income-oriented investors seeking regular income from their investments. Companies with high payout ratios can attract these investors. It helps these investors assess how much of the company's profits are being distributed as dividends, helping them to choose investments that align with their income needs.
Useful for comparisons. The dividend payout ratio allows investors to compare the dividend policies of companies within the same industry. By comparing payout ratios, investors can gauge which companies prioritize returning profits to shareholders versus reinvesting them in the business, helping them make more informed investment decisions.
Assess management’s confidence in future earnings. A high dividend payout ratio can signal that management is confident in the company's future earnings and cash flows. Companies typically avoid setting high payout ratios if they anticipate lower earnings. Stable or increasing dividends suggest that management expects future earnings to sustain the payouts, which can be a positive sign for investors.
Influence on stock price stability. Companies with consistent dividend payout ratios and a reputation for regular dividends often see less volatility in stock prices, as dividends can help provide a floor for the stock value. Investors may be less likely to sell shares during market downturns if they rely on the dividend income, which can contribute to greater price stability.

Overall, the dividend payout ratio is a versatile tool that provides insights into a company's financial health, management strategy, growth potential, and appeal to different types of investors.

Inverse of the Dividend Payout Ratio

It is also useful to examine the inverse of the ratio, which reveals how much cash the company is retaining for its own uses, perhaps to fund expansion, pay off debt, or retain as a cash reserve. If the retention amount is declining, this indicates that the company does not see a sufficient return on investment to be worthy of plowing additional cash back into the business.

Related AccountingTools Courses

Business Ratios Guidebook

The Interpretation of Financial Statements

Dividend Sustainability

Simply running the ratio for one year does not really show whether a business can continue to pay out dividends in a sustainable manner for a long time to come. One way to judge this issue is to track the dividend payout ratio over multiple years, to see if there have been any drops in dividends that could indicate cash flow concerns. Trend analysis will also likely reveal the points at which a company's board of directors decides to change the amount of dividends paid. In addition, review the stated strategy of the firm and how well it manages its cash flows, to see if it will be able to issue dividends in a reliable manner into the future.