A dividend refers to payments that a company makes out to its shareholders as a reward for investing in the company’s equity. The amount that is returned by the company to its shareholders as opposed to the amount that is kept for reinvestment is given by its dividend payout ratio.
What is a Dividend Payout Ratio?
Dividend payout ratio defines the relationship between the dividends paid by a company and its net earnings across a specific period. The ratio is represented in terms of a percentage.
If a company’s payout ratio is 30%, then it indicates that the company has channeled 30% of the earnings is made to be paid as dividends. Thereby, the remaining 70% of net income the company keeps with itself.
This retained amount goes toward mitigating liabilities, financing developmental endeavours like expansion or R&D, and reserves. The amount, which a company keeps as providence in a particular year, is known as retained earnings.
A company’s dividend payout ratio or DPR reveals the portion of its earnings that it funnels towards shareholders and retains for future growth and development.
Therefore, although DPR does not speak much about a company’s financial footing, it does portray its priorities – whether focused on pleasing shareholders or growth.
Furthermore, this specific metric is extensively used by dividend investors who ferret out companies that distribute a substantial and steady stream of dividends to its shareholders.
How is the Dividend Payout Ratio calculated?
The dividend payout ratio formula is expressed as:
DPR = Dividends paid / Net earnings
Example: Company CBA has paid out Rs.10 lakh as dividend to its common shareholders on 1st April 2020, according to its cash flow statement. Furthermore, according to its Profit & Loss Statement, Company CBA has realised a net income of Rs.1 crore in FY 20 – 21.
Therefore, DPR of Company CBA = (10,00,000 / 1,00,00,000) = 0.1 or 10%
Alternatively, DPR is also computed on the basis of per-share. In that case, both the dividend paid out and net earnings would need to be divided by the number of outstanding shares.
Ergo, DPR = DPS / EPS; where DPS represents dividend per share and EPS refers to earnings per share.
Example: Company XYZ, for the Financial Year 20 – 21 paid out Rs.4 per share as dividend and recorded net earnings of Rs.20 lakh. The number of its outstanding shares amounts to 200,000.
Here, since the number of outstanding shares is 2 lakh and its net earnings stand at Rs.20 lakh, its earnings per share would be Rs.10.
Therefore, DPR of XYZ = 4 / 10 = 0.4 or 40%
Alternatively, a dividend payout ratio can be calculated in relation to the retention ratio as well. It is the percentage of net earnings that a company retains as opposed to DPR, which is the portion of net income distributed as dividends.
In that case, DPR = 1 – Retention Ratio
That is because both DPR and RR form 100% of a company’s earnings in a specific period.
Example: Company DEF realizes a net income of Rs.50 lakh in FY 20 – 21. It retained 70% of those earnings for clearing its debts and financing an R&D project and disseminated the rest as dividends among its shareholders.
Ergo, the dividend payout ratio of DEF = 1 – 70% or, 1 – 0.7 = 0.3 or 30%
To avoid the hassle of manual calculation of DPR, investors can also make use of a dividend payout ratio calculator.
Dividend Payout Ratio with Respect to Dividend Yield
The dividend yield is the rate of return on stocks as compared to DPR, which is the percentage of net income paid out as dividends. The dividend payout ratio is more commonly used as a measure of dividend as it signifies a company’s ability to pay dividends and also portrays its priorities.
A dividend yield example: A company announces Rs.10 per share as a dividend when the market price of that share is Rs.50. In that case, the dividend yield would be 20%.
A dividend payout ratio example: A company pays out Rs. 10 lakh as dividends in a year when it realised a net income of Rs.1 crore. Here, its DPR would be 10%.
Interpretation of Dividend Payout Ratio
As mentioned previously, the dividend payout ratio is a crucial metric to understand a company’s priorities. However, that is only a single consideration when interpreting a company’s dividend payout ratio. One of the most critical considerations that need to be made when analysing DPR is the maturity of a company.
Typically, companies that are still in their growth phase would possess a considerably low dividend payout ratio, sometimes even zero. That is because a company that is still growing would channel most or all of its net income toward future growth rather than paying dividends to shareholders.
Therefore, growing companies that pay a high percentage of dividends out of its net income is most often a red flag for investors. Since higher dividend payments mean lower funds to finance developmental projects, such company’s stock prices would eventually go down.
Consequently, share prices of growing companies with low or zero dividend payout ratios would, in all probability, increase over time. Conversely, companies in their growth phase with high DPR would witness lowering share prices due to perceived inability to sustain.
Nevertheless, typically companies that pay high and consistent dividends are most often those that have already matured and have very little room for further growth. Ergo, share prices of such companies witness only small-scale fluctuations and stay relatively stable.
Thence, such stocks are more suitable for dividend investors. Conversely, stocks of growing companies with low DPR are apposite for investors aiming for accelerated wealth creation. Therefore, factoring in an organisation’s phase of maturity is crucial during dividend payout ratio interpretation.
However, merely considering maturity does not suffice the interpretation of DPR.
One must also take into consideration the industry to which a company belongs before making a judgement based on its dividend payout ratio.
Based on industries, DPR can vary among companies that share a similar level of maturity.
For instance, tech-intensive companies, albeit being industry leaders, have to spend substantial amounts towards Research & Development. Otherwise, such companies would be left behind by their competitors. For that reason, tech companies typically have low dividend payout ratios compared to other industries.
Similarly, industries that can potentially grow owing to changing circumstances and market demands often retain most of their income rather than distribute it among shareholders as dividends.
What is Dividend Sustainability?
Dividend sustainability is another inference that investors can make from assessing a company’s DPR. It refers to how long a company can sustain with the scale of dividends it is distributing at any point in time.
For instance, if a company that is still in its growing phase distributes the lion’s share of its net income as dividends, then it can be considered that such an organisation would not sustain.
Furthermore, if a company, be it any stage of maturity, has a 100% or above dividend payout ratio, it means that such a company is paying more than it is earning. Such a payout strategy is widely considered unsustainable. However, in some exceptional cases, it could be that a company has faced a few hiccups in a particular year due to which its net income has dwindled. Still, to continue its consistency in dividend payment, it afforded a DPR of 100%.
Therefore, it is crucial to contextualise a ratio against possible circumstances when assessing it. Moreover, it is necessary to look at DPR trends of an organisation rather than in isolation. DPR trends often betray if a company is growing, mature, or falling.
For instance, if a company’s dividend payout ratio is consistently rising, it implies that such an organisation is moving toward a more stable revenue-generating phase and can afford to maintain dividends while continuing to grow.
Contrarily, if there is a sudden spike in DPR in one particular year, there could be two inferences from this – such organisation has realised abounding profits in that year or is trying to lure shareholders into investing in it.
The latter raises a red flag. Simply because, it cannot continue with that scale of dividend distribution and would have to lower it, which, in turn, reflects poorly on its stock prices. Additionally, if a company has to jack up its share prices through a high dividend, it means that the company does not have much net income to finance its endeavours. Nevertheless, when assessing the DPR of a company, one should keep into consideration the factors described above before reaching any conclusion.