Many investors rely on dividends from stocks to fund part of their retirement. Dividends are a popular form of income investment because they have a lower tax rate compared to fixed income and can keep pace with inflation when done right.
Estimating dividend income is necessary for budget planning. Most investors are familiar with tracking the dividend yield of different stocks to help balance total dividend income and generate predictable income.
The dividend yield compares the size of a dividend with the price of the stock. It is a convenient way to represent shareholders’ rate of return on their investment.
The dividend payout ratio is another helpful metric, too. Calculating the dividend payout ratio is helpful as an indicator of dividend sustainability. Let’s look at the dividend payout ratio more closely.
What is the Dividend Payout Ratio Formula?
The dividend payout ratio is a key ratio that calculates the proportion of a company’s net income distributed as dividends to shareholders. It is a useful tool for understanding what percentage of a company’s earnings are distributed to shareholders in dividend form.
The dividend payout ratio formula is:
Dividend Payout Ratio = Dividends Paid/Net Income
The dividend payout ratio can also be expressed:
Dividend Payout Ratio = 1 – Retention Ratio
Where, on a per-share basis, the retention ratio can be expressed as
Retention Ratio = (EPS-DPS)/EPS
EPS = earnings per share
DPS = dividends per share
Companies report their EPS on the income statement in their annual and quarterly SEC filings 10-K and 10-Q.
What is a Good Dividend Payout Ratio?
Depending upon your goals as an investor, it makes sense to research the company strategy behind the dividend payout ratio before purchasing a stock for dividend income.Depending upon your goals as an investor, it makes sense to research the company strategy behind the dividend payout ratio before purchasing a stock for dividend income. Click To Tweet
A high dividend payout ratio means the company is paying out large dividends relative to net earnings. This could be good because the company is devoted to returning a majority of their earnings back to shareholders. However, it also means the dividend is in danger of being cut if earnings decline or the company doesn’t perform as expected.
On the surface, you might think a low dividend payout ratio is a red flag. In reality, a low payout ratio is not necessarily a bad thing. Consistently high ratios may signal a company is sacrificing long-term growth. A lower payout ratio may signal a company is in growth mode, reinvesting in the company rather than paying out larger dividends to shareholders. Along with funding growth, a low payout ratio also means their is plenty of room for dividend increases in the future. A few bad earnings reports won’t immediately put the dividend payment in danger.
Some advisors note that dividend-growing stocks maintaining a payout ratio below 50% can create an investor-friendly balance between dividends for shareholders and funding company growth. Investors who are not as concerned with future growth may choose stocks with higher dividend payout ratios.
Dividend Payout Ratio Example
Let’s say Acme Company reports a net income of $200,000 and issues $20,000 in dividends. The payout ratio would then be:
$20,000 / $200,000 = 10%.
Acme company may want to attract investors who are prioritizing income returns.
Across town, Widget Corp boasts a net income of $350,000 while issuing $10,000 in dividends. They are paying fewer dividends this year because they are investing in cutting-edge technology to increase the efficiency of widget production. Their payout ratio would be:
$10,000 / $350,000 = 2.8%
Widget Corp may attract growth-focused investors who are interested in holding the stock for the long term and will reap the long-term benefits of recent capital investments.
The dividend payout ratio helps assess a dividend’s sustainability. The ratio shows what share of earnings a company is returning to shareholders versus investing in growth, building cash reserves, or paying off debt. A high or low ratio isn’t inherently good or bad. It depends upon the company and the investor’s goals.
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