Have you ever wondered how feasible an investment is and what returns it provides you with? As an investor in the market, I have enjoyed the fact that certain companies provide shareholders with dividends. This method of sharing profits has encouraged me to continue staying invested in certain companies via their stocks. But I came across the term “dividend payout ratio”, and it got me thinking, “what is dividend payout ratio and why is it necessary?”
Let’s find out.
For the uninitiated, this ratio is used to set the total amount of dividends that are paid to shareholders against the net income of the company under consideration. Simply put, it highlights the percentage of earnings paid to shareholders in the form of dividends. The amount that isn’t shared with shareholders remains under the company’s hold. The remaining amount held back can be used for several reasons like business expansion, repaying debts etc.
For example, if the dividend payout ratio is 33%, it means that the company has used 33% of its profits as dividends, and the company has held back the remaining 67%.
This ratio can be calculated in two different ways that have been outlined below.
By dividing the yearly dividend per share from the earnings per share (or EPS). This essentially means that you must divide dividends from net income.
Example: A company decides to pay out 20 lakhs as dividends to its shareholders on a particular date. As per the profit and loss statement, the net earnings of the company are ₹1 crore. So as per the formula:
It can also be calculated by subtracting the retention ratio from 1. It is the percentage of net earnings that a company retains in relation to the dividend payout ratio (DPR), which is the net income distributed in the form of dividends.
Dividend Payout Ratio = 1 – Retention Ratio
Where Retention Ratio = Earnings per share – dividends per share/earnings per share
A company has reported a net income of ₹50 lakhs and has retained 60% of those earnings for clearing its debt and investing in expansion, and the remaining is given as dividends. Hence
Dividend Payout Ratio = 1 - 0.6 = 0.4 or 40%
In order to calculate a company’s dividend payout ratio, you must be aware of where exactly you can find its net income, earnings per share and diluted earnings per share. Fortunately, each of these figures is available at the bottom of a company’s income statement. In the case of dividends paid, direct your attention toward the company’s dividend announcement or balance sheet. Here, the company’s outstanding shares, as well as its retained earnings, are mentioned.
A number of factors must be considered when interpreting a company’s dividend payout ratio.
Maturity - The level of maturity of a company is one of the most important considerations.
When looking at new companies focused on growth, whose aims are expansion, product development and entering new markets, they can be expected to reinvest most if not all of their earnings. If such companies, therefore, have a modest if not non-existent payout ratio, they can be forgiven. (Worth noting here is the fact that companies that don’t pay dividends have a payout ratio of 0 per cent. Conversely, companies that pay their entire net income as dividends have a payout ratio of 0 per cent).
In contrast, when looking at older companies that have established themselves, investors’ patience could be tested, and activists may intervene if they have a low dividend payout ratio. Take, for instance, tech giant Apple (AAPL), which has enjoyed enormous success in the past few decades. When the company brought on a new CEO (Tim Cook), in 2011, it chose to pay dividends in the following year as Cook felt that a 0% dividend payout ratio was hard to justify given the company’s enormous success.
A high payout ratio indicates that a company has moved beyond its initial growth stage. It is also indicative of share prices being unlikely to appreciate at a rapid pace.
A dividend payout ratio can be particularly illuminating in terms of clarifying what a dividend’s sustainability is. Companies are incredibly wary of reducing dividends as it can bring their stock prices down. Further, it can cast a bad light on the abilities of their respective management teams as well.
In case a company’s payout ratio exceeds 100 per cent, it returns more money to its shareholders than it is earning. This is likely to force the company to reduce its dividends or stop making these payments altogether. That said, this outcome isn’t inevitable.It isn’t unusual for a company to endure a bad year without putting its payouts on hold. Continued dividend payouts despite the tough times are often in a company’s best interest. By considering future earning expectations and calculating a forward-oriented payout ratio, it is possible to understand the context of a backwards-oriented payout ratio.
Being aware of long-term trends within a payout ratio is important. While steadily rising ratios are indicative of a business model that is healthy and maturing, a spiking payout ratio may indicate that the dividend is chartering towards an unsustainable territory.
While dividend yield indicates the simple rate of return via cash dividends to shareholders, the dividend payout ratio indicates the extent to which a company’s net earnings are paid in the form of dividends. For example, if a company announces ₹10 per share and the market price is ₹25 per share, then the dividend yield is 40%.
Although several investors pay close attention to a company’s dividend yield, a high yield isn’t always indicative of good news. In case a company pays out the majority of its profits to its shareholders or say over 100 per cent of its earnings in the form of dividends, then the dividend yield may not be sustainable.
Consider the following example to understand this better. Company XYZ provides an 8 per cent dividend per yield, paying out INR 400 per share in dividend while only generating INR 300 per share in its earnings. This indicates that the company is paying 133 per cent of its earnings in dividends. This is unsustainable over the long haul and could result in a dividend cut.
Keeping this in mind, a dividend payout ratio is a superior indicator as it highlights a company’s ability to consistently distribute dividends in the long run. This ratio is strongly tethered to the cash flow of a company.
The dividend yield makes clear the extent to which a company has made payments via dividends over a year. Rather than this yield being presented in the form of a currency, it is shown as a percentage. This makes it easier to comprehend how much return per Rupee invested a shareholder receives via dividends.
This dividend yield is calculated by dividing the annual dividends per share from the price per share.
Different industries have different dividend payouts tethered to them. Like most other ratios, it is worth comparing dividend payouts emerging from the same industry. It is important to understand that dividends aren’t the sole method via which a company can return value to its shareholders. A dividend payout ratio, therefore, doesn’t shed light on the complete picture. This broader vision can be seen by taking into account the following.
Augment Payout Ratio - If you were to consider the augmented payout ratio, it takes into account share buybacks. Its formula requires you to divide the sum of dividends and buybacks from net income for the same time frame. In case the result is too high, it may be indicative of a focus on short-term boosts to share prices at the cost of long-term growth and reinvestment.
Performing Subtractions – In order to see the complete picture of a company and understand the broader ways in which it returns value to its shareholders, consider subtracting preferred stock dividends. This applies to companies that issue preferred shares.
This list is not exhaustive, and it depends on the investor as well since everyone has a different style of investing in stocks and uses different parameters to make decisions.
Dividends are a way of rewarding shareholders for staying invested in the company. However, it’s also important to gauge various parameters like DPR, dividend yield, the type of company, and the past dividend distribution that the company is issuing dividends as these will indicate potential red flags before reaching any conclusion.
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The dividend payout ratio works by setting the total amount of dividends that are paid to shareholders against the net income of the company under consideration. Simply put, it highlights the percentage of earnings that are paid to shareholders in the form of dividends
Dividend payouts vary from one industry to another so generalisations cannot be made. That said, dividend payout that fall in the range of 0 to 35 per cent are viewed in a good light.