Dividend Payout Ratio

Dividend Payout Ratio Definition

The dividend payout ratio is the amount of dividend that a company gives out to its shareholders out of its current earnings. The earnings that the company retains with it after paying off the dividends are “Retained Earnings.” And the company invests in these for its growth and future. In other words, the total earnings of a company are a mix of two essential parts, i.e., the Dividend payout ratio (the dividend it pays) and the Retention Ratio (the amount it retains for re-investing in the business).

Dividend Payout Ratio Formula

We can calculate dividend payout using two different equations. Each of the two equations can be easily computed from the data in your financial statements. And both give the same results.

It is important to note that both the numerator and denominator in this equation do not include any preference dividends or preference shares. And only include the dividend per share to common equity shareholders. To arrive at the numerator, you can divide the total dividend payable to equity shareholders by the company’s total number of outstanding equity shares. Similarly, for calculating the earnings per share, divide the company’s total earnings by the number of equity shares.

In this equation, we do not include preference dividends or shares in calculating total dividends and net income. This equation is relatively simpler as it requires lesser calculations. You can straight away pick up the concerning figures from the financial statements.

And, the third equation to calculate the dividend payout ratio is:

Example of Payout Ratio

Let us try to understand this concept with the help of an example.

Following is the data of two companies, Alpha Ltd. and Beta Ltd., for three years.

The details of the dividend distributed and earnings of Alpha Ltd. and its payout ratio are as follows:

The details of the dividend distributed and earnings of Beta Ltd. and its payout ratio are as follows:

You can also use our Dividend Payout Ratio Calculator for a quick calculation.

Interpretation

Both Alpha Ltd. and Beta Ltd. have a dividend payout ratio of 25% over three years, but they have different approaches to dividend distribution. Alpha Ltd. is distributing dividends at a constant rate, whereas Beta Ltd.’s dividend payouts are fluctuating.

A higher dividend payout ratio is often seen as a good thing, but it’s important to consider the context. For Alpha Ltd., the constant dividend payout ratio may be seen as a positive sign of a stable and predictable dividend payout policy, which could be attractive to some investors. However, it’s also possible that the company isn’t reinvesting as much in the business, which could limit future growth opportunities.

Beta Ltd.’s fluctuating dividend payout ratio may indicate that the company is more focused on reinvesting in the business, which could maximize growth opportunities in the long term. This could be seen as positive by investors who prioritize long-term growth over immediate returns.

Low vs High Dividend Payout Ratio: Which is Better?

It may seem that a company having a higher dividend payout ratio is in a better position than a company with a lower ratio. However, it is not necessarily true. What needs to be looked at is how consistently the company has been paying out those dividends. For say, there are two companies Company A with a stable 20% payout ratio for, say, 10 years is more trustworthy than Company B with a payout ratio of 30% but which is consistently on the decline over the years. In the latter case, it is possible that the company may not be able to pay dividends at all in the coming years. Consistency or long-term trends are what you should focus on, more than the dividend rate.

It is also imperative to know that most of the startup companies or the companies that are looking to expand their business, understandably, have a lower dividend payout ratio. Because they want to retain as much of the earnings and use it to bring the company up, they start giving higher dividends when they do not have sufficient projects to invest in.

Therefore, if an investor is looking for a steady dividend income, you can always keep this factor in mind and look for companies that have been in the running for a long time and with a good performance record. Though beware of extremely high dividend payout ratios as that means the company is giving out most of its earnings. And relying on a negligible amount to invest in its future operations is not a good sign.

Cautions

Thus the dividend payout ratio tells us how many portions of the earnings of the company are being paid to the equity shareholders. Analyzing the same over the years can give us the status of whether it is increasing/decreasing and what relation it has with the earnings. While analyzing a company on the basis of its payout ratio, one has to be very careful and should look at other factors too that affect the earnings of the company. For example, a new start-up company may distribute a low dividend but may have high earning potential. Therefore, no one ratio should be considered in isolation before making investment decisions.

Conclusion

The dividend payout ratio lets an investor calculate the percentage of the dividend that the company has decided to distribute out of its net earnings. It is of utmost importance to keep track of the ratio of a company over the years to take a call as to which company would be the right choice to invest in.

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.