Simply put, the payout ratio tells you how much of the company’s profits come back to you as a dividend. You become an investor for the profits, and a dividend investor specifically because you want to pocket some of those profits now. The payout ratio shows you exactly how much of those profits actually land in your pocket.
To calculate the payout ratio, divide the company’s dividends per share by the earnings per share (both can be found on the company’s income statement):
Payout Ratio = Dividends per Share / Earnings per Share
Use the following general guidelines to help measure how well various companies’ payout ratios stack up:
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Low: Anything much lower than 50 percent is cause for investigating further. Don’t automatically shun companies with low payout ratios, because they do have room to grow the size of the dividend. Many growth companies have low payout ratios because they continue to reinvest in the business; these companies offer potential for increased dividend payments as well as capital appreciation in stock price. For example, regional banks often pay out between 30 and 50 percent of their profits. But if a company with a low payout ratio isn’t growing fast, you know management can pay out more but chooses not to.
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Traditional: 50 percent is the traditional payout ratio, meaning the company is paying 50 percent of its profits to the shareholders in the form of dividends.
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Standard: 50 to 70 percent is an average range and should not generate any concern. Remember that the range may vary for some industries. Utilities, for example, sometimes pay as high as 80 percent, which is okay for that industry.
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High: A higher payout ratio is always better because it means more money in your pocket. However, you don’t want to see a payout ratio of 100 percent or higher. A 100 percent payout ratio means nothing is left to invest in the business. A dividend payout that exceeds the quarterly profit is a big cause for alarm and usually indicates an inevitable dividend cut. Also, a high payout ratio leaves little room for error. If most of the earnings are paid out as dividends, a big drop in earnings one quarter may lead to the company taking on debt to make the payments or an immediate dividend cut. Either way, it’s a bad sign.
If a company keeps increasing its dividend, but the payout ratio remains below 50 percent, that’s a clear sign of strong earnings growth. Procter & Gamble has raised its dividend payment for nearly 60 years while paying out between 40 and 50 percent of its quarterly earnings.
