What is the 'Payout Ratio'
Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. The payout ratio can also be expressed as dividends paid out as a proportion of cash flow.
The Payout Ratio is calculated as follows:
Payout Ratio = (Dividends per Share (DPS) / Earnings per Share (EPS)) x 100
Payout Ratio = (Total Dividends Paid / Net Income) x 100
The Payout Ratio is also known as the dividend payout ratio.
BREAKING DOWN 'Payout Ratio'
At the end of a period, some companies pay out dividends to shareholders. The dividends are paid out of the company's net earnings, and represent a return on investment to shareholders. Each year, a company that decides to pay dividends to shareholders declares a dividend payment and the amount of dividend per share. For example, a company may declare a dividend of $0.35 in June to be paid to its investors in August. An investor that owns 100 shares of the company will receive $0.35 x 100 = $35 on the dividend payment date in August.
The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payments. It is the amount of dividends paid to shareholders relative to the total net income of a company. For example, Company X with earnings per share of $1 and dividends per share of $0.60 has a payout ratio of 60%. Company Y with earnings per share of $2 and dividends per share of $1.50 has a payout ratio of 75%. Which company has the more sustainable payout ratio?
It really depends, since there is no single number that defines an appropriate payout ratio. The adequacy of the payout ratio depends very much on the sector. Companies in defensive industries, such as utilities, pipelines, and telecommunications, have stable and predictable earnings and cash flows, and thus can support much higher payouts than cyclical companies. Companies in cyclical sectors, such as resources and energy, typically have lower payouts since their earnings fluctuate considerably in line with the economic cycle.
In the previous example, if Company X is a commodity producer and Company Y is a regulated utility, Y’s dividend sustainability may be better than that of X, even though X has a lower absolute payout ratio than Y.
Some companies pay out all their earnings to shareholders, while some only pay out a portion of their earnings. If a company pays out some of its earnings as dividends, the remaining portion is retained by the business. To measure the level of earnings retained, the retention ratio is calculated. A lower payout ratio indicates that the company is using more of its earnings to reinvest in the company in order to grow further. In this case, the retention ratio will be high. A high payout ratio may mean that the company is sharing more of its earnings with its shareholders. If this is the case, the retention ratio will be low. A payout ratio greater than 100% may be interpreted to mean that the company is paying out more in dividends than it is earning, which is an unsustainable move.
Many companies set a target range for their payout ratios, and define them as a percentage of sustainable earnings, or cash flow. The companies with the best long-term record of dividend payments have stable payout ratios over many years. While many blue-chip companies increase their dividends year after year, since they have steady earnings growth as well, their payout ratios remain remarkably stable over extended periods.