Dividend Payout Ratio: Calculation and Impact

Dividend Payout Ratio: Calculation and Impact

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Jaya
Jaya Sharma
Senior Executive Content
Updated on Dec 7, 2023 17:13 IST

Dividend Payout Ratio represents the amount of earnings after tax (EAT) of a company that is paid to its shareholders. The payout ratio is calculated by dividing dividends paid by EAT.

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The dividend payout ratio is an important financial metric that provides valuable insights into a company’s dividend-paying capacity and financial health. In this article, we will be learning to calculate the dividend payout ratio in detail.

Table of Contents

What is dividend payout ratio?

Dividend payout ratio refers to a financial metric that measures the percentage of a company’s earnings paid out to shareholders as dividend. This ratio is calculated by dividing the total amount of dividends paid by the company by its net income for a given period. 

Dividend Payout Ratio = Dividends Paid Out / Net Income

Importance

Here are some key reasons why the dividend payout ratio is important:

  1. Financial Health Indicator: The dividend payout ratio can be a good indicator of a company‘s financial health. A consistently high payout ratio may indicate that the company is financially stable and generating healthy profits, while a consistently low payout ratio may indicate financial weakness.
  2. Dividend Sustainability Measure: The payout ratio can also help investors assess the sustainability of a company’s dividend payments. A high payout ratio may suggest that the company is paying out more in dividends than it can afford, while a low ratio may suggest that the company has the financial strength to sustain its dividend payments.
  3. Industry Peers Comparison: Comparing a company’s payout ratio with its industry peers can provide insights into the company’s dividend policy and financial performance relative to its competitors.
  4. Stock Price Influence: The payout ratio can also influence a company’s stock price. A higher payout ratio may lead to a higher dividend yield, which can attract investors and increase demand for the company’s stock. Conversely, a lower payout ratio may signal to investors that the company is reinvesting more of its earnings into growth opportunities, which can also positively affect the stock price.
  5. Long-term Investment: The ratio is particularly important for long-term investors who are seeking reliable income streams from their investments. A company with a consistent history of paying dividends and maintaining a stable payout ratio may be an attractive investment for income-oriented investors.
Check out these videos to learn more about dividend payout ratio:

 

How to Calculate Payout Ratio?

Dividend payout ratio is calculated by dividing the total amount of dividends paid out to shareholders by the company’s net income for a given period.

Dividend Payout Ratio = Dividends Paid / Net Income

Here:

  • Dividends paid: total amount of dividend distributed among shareholders during the period being analyzed. This includes all dividends paid to both common and preferred shareholders.
  • Net income: Also referred to as profits and earnings, it is the total amount of income earned by companies during the same period. It is subtracted from any expenses and taxes. 

Example for Calculating Dividend Payout Ratio

Let us understand this with the help of an example. Suppose, if a company has paid out $1 million in dividends to shareholders during a given year. It had a net income of $5 million for the same year, the ratio would be 20%.

Let us take another example. Suppose that company ABC has paid $2 million as dividends to shareholders during the previous year. It had a net income of $8 million during this period. Here, the payout ratio will be $2 million / $8 million which is equal to 0.25 or 25%.

Do note that the ratio can be calculated on an annual, quarterly, or even monthly basis. This varies depending on the investor’s needs and preferences. Since different companies have different dividend policies, it can affect their payout ratios. 

Types of Payout Ratio

A dividend payout ratio provides valuable insights into its financial health and dividend-paying capacity. Let us learn about the two measures of ratio:

1. High Payout Ratio

This indicates that a company is paying out a large percentage of its earnings as dividends. The company might have fewer funds that can be used for reinvestment in business or future growth opportunities. It can also be a positive indicator since income-oriented investors will favour companies that pay regular dividend payments. However, if the payout ratio is too high, it might indicate that the company is under too much debt and has difficulty financing its dividend payments. This could lead to financial instability in the long run.

2. Low Payout Ratio

A low payout ratio indicates that the company is retaining a major portion of its earnings to reinvest in the business or to pursue growth opportunities. This may be seen as positive by growth-oriented investors who prioritise potential future returns. A low payout ratio may also suggest that a company has the financial strength to sustain its dividend payments even during difficult times. However, a very low ratio may also indicate that a company is not utilising its capital efficiently and may not be generating sufficient profits to support future dividend payments.

Factors Impacting Payout Ratio

There are several factors that can impact the payout ratio. Here are a few examples:

  1. Industry: Different industries may have different dividend policies and payout ratios. For example, mature companies in stable industries, such as utilities, may have higher payout ratios because they have less need for reinvestment, while growth-oriented companies in fast-paced industries, such as technology, may have lower payout ratios because they require more capital to fund their growth initiatives.
  2. Financial Performance: A company’s financial performance can affect its ratio. If a company is generating healthy profits and has strong cash flows, it may have a higher ratio because it has more funds available for dividend payments. Conversely, if a company is experiencing financial difficulties, it may have a lower payout ratio as it focuses on conserving cash.
  3. Growth Opportunities: A company’s growth opportunities can also impact its payout ratio. If a company has significant growth potential, it may choose to retain more of its earnings to fund future growth initiatives, leading to a lower payout ratio. Conversely, if a company has limited growth opportunities, it may distribute more of its earnings as dividends, resulting in a higher payout ratio.
  4. Shareholder Preferences: A company’s dividend policy can also be influenced by the preferences of its shareholders. For example, if a company has a large percentage of income-oriented investors who prioritize regular dividend payments, it may have a higher ratio to attract and retain these investors.
  5. Tax Implications: Tax laws and regulations can also impact a company’s dividend policy and ratio. In some countries, companies may receive tax incentives for paying out dividends, while in others, companies may be taxed at a higher rate for distributing dividends.

Dividend Payout Policy

Dividend policy refers to the guidelines a company follows to decide how much of its earnings will be distributed to shareholders as dividends and how much will be retained in the company. The dividend payout ratio plays a crucial role in these policies. Common types of dividend policies include:

  1. Regular Dividend Policy: Companies with this policy pay out a fixed amount or a stable percentage of earnings as dividends regularly, regardless of the company's earnings fluctuations. This policy is often adopted by companies with stable and predictable earnings.
  2. Stable Dividend Policy: Unlike the regular dividend policy, a stable policy aims to keep the dividend per share at a steady level. Companies might set a relatively low fixed dividend payment and supplement it with additional or special dividends in profitable years.
  3. Residual Dividend Policy: Under this policy, dividends are paid out from the residual or leftover earnings after all operational and expansion costs are covered. This policy is often favoured by companies focusing on growth and expansion, where reinvestment priorities can vary significantly from year to year.
  4. No Dividend Policy: Some companies choose not to pay dividends at all, instead reinvesting all profits back into the business. This is common in startups and high-growth companies where capital is crucial for expansion and market penetration.

Difference between the Dividend Payout Ratio and Dividend Ratio

Here's a comparative table that outlines the key differences between the Dividend Payout Ratio and Dividend Ratio (assuming that the Dividend Ratio is interpreted as Dividend Yield):

Parameter Dividend Payout Ratio Dividend Ratio
Definition The proportion of net income paid out as dividends to shareholders. Annual dividend payment divided by the stock's current price.
Calculation Total Dividends Paid / Net Income Annual Dividends per Share / Price per Share
Expressed As Percentage of earnings distributed as dividends. The dividend ratio formula is in the form of percentage that shows how much a company pays out in dividends each year relative to its stock price.
Purpose Indicates how much of a company's profit is given back to shareholders as dividends. Indicates how much dividend income an investor is likely to get for each dollar invested in the stock.
Investor Focus Useful for understanding a company's dividend policy and financial health. Helpful for investors looking for income or yield from their stock investments.
Implications A high ratio may indicate a strong commitment to paying dividends or limited opportunities for reinvestment in the business. High yield can be attractive to income investors but may also indicate a low stock price due to company challenges.
Industry Relevance More relevant for the analysis of the company's earnings allocation and financial strategy. More relevant for comparing investment returns across different stocks or sectors

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About the Author
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Jaya Sharma
Senior Executive Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio

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