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).
How to Calculate Dividend Payout Ratio?
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.
Formula / Equation
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.
Or, 1 – Plowback Ratio
Let us understand the concept with a practical example.
Suppose the annual dividend paid by ABC Company is Rs. 30 per share. The net earnings of ABC Company during this period is Rs. 100 per share.
Using the below formula, we can calculate the ratio as follows:
The dividend payout ratio is 30%. It automatically means that 70% (100-30) is the retention ratio. With which, the company has decided to fuel its long-term objectives and overall growth.
For a quick calculation, refer Dividend Payout Ratio Calculator
Now 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. A company with a stable 20% payout ratio for, say, 10 years is more trustworthy than a company 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.
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.
Read Dividend Payout Policies for more details.
Quiz on Dividend Payout Ratio