What is the dividend payout ratio (DPR)?
Dividends are payments made by publicly listed companies to investors. The dividend payout ratio (DPR) is the amount of dividend that a company gives out to its shareholders as a percentage of its current earnings. Put another way, the dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends.
Companies that make a profit at the end of a fiscal period have a few options on how they use the profit they’ve earned. They can pay it to shareholders as dividends (or indirectly via stock buybacks), they can retain it to reinvest in the business for growth, or they can do a combination of the two. The portion of the profit that a company chooses to pay out to its shareholders can be measured with the payout ratio.
Dividend payout ratio explained
The dividend payout ratio is an important marker for investors as it indicates which companies are paying out a reasonable portion of their net income to shareholders. Conversely, it helps to identify companies paying unreasonably high dividend percentages, which may attract investment in the short term but are unlikely to be sustainable over longer time horizons. It is also worth noting that companies without positive earnings can’t afford to distribute dividends to shareholders.
Technology giants Amazon and Microsoft are infamous for not paying a dividend for many years as they focussed on increasing the size and scale of their business. A good general guide for income-oriented investors is that smaller, fast-growing companies usually report a relatively lower dividend payout ratio as earnings are heavily reinvested into the company while bigger, more mature companies usually report a higher dividend payout ratio. There isn’t an optimal dividend payout ratio, as the DPR of a company depends heavily on the industry they operate in, the nature of their business, and the future business plan of the company.
How to calculate the dividend payout ratio
The dividend payout ratio that shareholders receive may vary significantly and depends on a range of factors like the maturity of the individual stock or company, the sector it operates in and the country it is listed in. There are a few ways to calculate the dividend payout ratio but the simplest method is to divide the total dividends paid out over a year (the sum of four quarters) and divide it by the net income, or earnings, during the same period. For example, if a company’s total profits were $100,000, and its dividend is $25,000, then the dividend payout ratio would be 25 percent.
However, this would be on the low side as a dividend payout ratio of 30-50% is considered healthy, while anything over 50% could be unsustainable. A high payout ratio also implies that the share price is unlikely to appreciate rapidly. Because dividend payouts vary widely by industry, they are most useful in comparing like-for-like companies within a given sector. Real estate investment partnerships (REITs) in the US, for example, are legally obligated to distribute at least 90% of earnings to shareholders as they enjoy special tax exemptions.
What does a high or low dividend payout ratio mean?
A high DPR usually means that the company is reinvesting less money back into its business, while paying out relatively more of its earnings in the form of dividends. Such companies tend to attract income investors who prefer the assurance of a steady stream of income to a high potential for growth in share price. ASX stalwarts like Westpac, Coles and Telstra are good examples that pay regular dividend income to investors. By doing so, these companies foster goodwill among their shareholders, drive demand for the stock and signal to the market that business is good.
On the other hand, a low DPR suggests that the company is reinvesting profits back into its business. These are likely to be smaller, often rapidly growing companies reinvesting their earnings into the business to meet future growth and expansion targets. These types of companies tend to attract growth investors who are more interested in potential profits from a significant rise in share price, and less interested in dividend income. It is therefore crucial to review a company’s historical DPR to determine whether the company’s likely investment returns are a good match for the investor’s overall investment strategy.
How does DPR differ from dividend yield?
A stock’s dividend yield is a different but equally important measure. The dividend yield is the ratio of the dividend paid relative to the share price of the company's stock. For example, if a company’s annual dividend is $2.50 and the stock trades at $50, then the dividend yield is 5%. Yields for a current year can be estimated using the previous year’s dividend or by multiplying the latest quarterly dividend by four, then dividing by the current share price.
Assuming the dividend is not raised or lowered, the yield will rise when the price of the stock falls and fall when the price of the stock rises. While dividend yield is the more commonly known and used term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future.
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