Dividend Payout Ratio

The dividend payout ratio is a company's dividends for a period divided by its earnings for the same period. On a per-share basis it is the dividend per share divided by earnings per share; on a total basis it is total dividends divided by net income. Either way it shows how much of what the company earned went to shareholders as cash and how much stayed in the business. The SEC's guide to financial statements notes that companies "almost never distribute all of their earnings," and that they usually reinvest them, which is the other half of the ratio. "Payout ratio" on its own is the common short form.

Earnings or cash. The standard version uses net income, an accounting figure that includes noncash items such as depreciation. Because dividends are paid in cash, some analysts compute a cash-flow version instead, dividing dividends by the cash the business generated after its capital spending. The two can tell different stories: a company with large depreciation charges can show a high earnings payout while comfortably covering the dividend from cash, and the reverse is also possible. Published figures are not all computed the same way, so it is worth checking which version a figure uses before comparing two companies.

What a level suggests, and what it does not. A low ratio means the company is keeping most of its earnings, which may fund growth, debt repayment or a cushion for bad years. A high ratio is common in mature businesses with limited room to reinvest. A ratio above 100% means the dividend exceeded the period's earnings, so it was paid from cash on hand, borrowing or earnings kept in earlier years. That can be a temporary result of an earnings dip, with the board choosing to hold the dividend steady, or it can be a sign the dividend is at risk; the ratio alone cannot say which. When earnings are negative the ratio has no useful meaning.

Industry and legal context. What counts as a normal ratio depends heavily on the business. Real estate investment trusts are the clearest special case: to keep their tax status, Internal Revenue Code section 857(a)(1) requires a REIT's dividends to equal at least 90 percent of its income as the REIT rules compute it, so its payout is set largely by statute rather than by management's view of the future. Comparisons are most meaningful among similar companies.

The link to dividend yield. The dividend yield is the dividend divided by the share price. Since the dividend equals the payout ratio times earnings, the dividend yield also equals the payout ratio times the earnings yield (earnings per share divided by price). A high yield can therefore come from a generous payout, a low share price, or both, and the payout ratio helps separate the two. Share repurchases are another way companies return cash and are not counted in the dividend payout ratio.

Take the dividends paid per share over a year and divide by earnings per share for the same year, or divide total dividends by net income. Multiply by 100 to express it as a percentage, and subtract from 100% to get the retention ratio.

For example, with invented figures: a company earns $4.00 a share and pays $1.60 a share in dividends. Its payout ratio is $1.60 ÷ $4.00, or 40%, and its retention ratio is 60%, so $2.40 a share stays in the business. If the shares trade at $80, the dividend yield is $1.60 ÷ $80, or 2%, which matches the payout ratio times the earnings yield: 40% × ($4.00 ÷ $80, or 5%) = 2%.

Now suppose earnings fall to $1.50 a share in a weak year and the board keeps the dividend at $1.60. The payout ratio becomes $1.60 ÷ $1.50, about 107%. The company has paid out more than it earned, and the extra $0.10 a share came from cash or earnings kept in earlier years. Whether that is alarming depends on whether the earnings drop is temporary, which the ratio itself does not reveal.

Pros

• Simple to calculate from figures every public company reports.
• Shows how much room a company has to keep paying, or raise, its dividend if earnings stay level.
• Helps explain a high dividend yield by separating generosity from a falling share price.

Cons

• Earnings include noncash items, so the ratio can misstate how well cash covers the dividend.
• A single year's figure can be distorted by a temporary rise or fall in earnings.
• Normal levels vary so much by industry, and by legal structure for REITs, that a figure means little without comparable companies.
• It ignores share buybacks, so it understates the total cash some companies return to shareholders.