Every company pays a portion of its earnings to its shareholders in the form of dividends. This percentage of a company’s earnings or cash flow that goes out to shareholders is denoted by the payout ratio.
It is the ratio between the amount of dividend paid by a company and its net income in a specific period. A payout ratio is a crucial metric for dividend investors and also for investors of all kinds at large.
The ratio is denoted in percentage terms and exhibits the proportion of net earnings distributed as dividends and retained by a company.
The retained portion is typically channelled towards financing maturation endeavours and managing liabilities and is also reserved for contingencies (retained earnings).
Payout ratio, more commonly referred to as dividend payout ratio (DPR), is the amount of dividend a company pays out in a specific period in regard to that period’s net earnings. Thus, the payout ratio formula is written as:
Payout Ratio = Dividend Payout / Net Income
Let’s assume Company XYZ announced a dividend payout of Rs.2 lakh for FY 20 – 21 when its annual income came about to be Rs.10 lakh, according to its Income Statement. Therefore, DPR would be the ratio between Rs.2 lakh and Rs.10 lakh, i.e. DPR = 200000 / 100000 = 0.2 or 20%.
Instead of manual calculation, investors can also resort to utilising a payout ratio calculator to eliminate the chances of miscalculation.
As mentioned previously, the ratio portrays the portion of net income distributed as dividends and the portion retained for other purposes. The percentage of net income that is not used for dividend distribution is called the retention ratio.
From this understanding, another formula for this ratio can also be derived as follows –
Dividend Payout Ratio + Retention Ratio = 1 [1 represents the whole of net income]
DPR = 1 – Retention Ratio
Considering the above example of Company XYZ, since it distributed 20% of its net income from FY 20 – 21, the remaining 80% of that income is retained for other purposes and is the retention ratio.
It is also expressed on a per-share basis. In this formula, both a company’s net income and the total amount of dividends it paid out are divided by the total number of outstanding shares of that organisation.
Considering the example of Company XYZ, let’s suppose that it has a total of 1 lakh outstanding shares. Thence, since its net income is Rs.10 lakh, its earnings per share (EPS) would come to be Rs.10. Similarly, since it paid out Rs.2 lakh as dividends, its dividend per share (DPS) would be Rs.2. Therefore, DPR = 2 / 10 = 0.2 or 20%.
It is one of the most critical metrics for investors on which to base their investment decisions. However, a couple of parameters play a crucial role in the analyses of companies via the stock payout ratio.
These are –
It denotes at which phase of growth a company is in at any point in time. Analysing this via its payout ratio adds further insight into the soundness of that ratio.
For instance, let’s consider the above example of Company XYZ. It distributed 20% of its net income as dividends for FY 20 – 21. Now, if that company is in the nascent stage of growth, that ratio might be frowned upon by most investors.
That is because, in the initial stages, any organisation is expected to utilise almost all its earnings toward further growth rather than dividend distribution. Investors might construe the company’s management to be unsound, and that perception might lead to lowering share prices.
However, if that company has already achieved some level of growth and is in the mid-stages or past that, then such a ratio is well received by investors of all kinds.
Another crucial consideration that plays a critical role in this ratio’s interpretation is the industry to which a company belongs.
For instance, companies in highly competitive and ever-evolving industries often exhibit extremely low to zero dividend payments on their stocks. One such example is the tech industry. Companies belonging to that industry need to invest enormous portions of their income into Research & Development to thrive.
Therefore, no single ratio can be pinpointed as ideal across industries. This consideration provides insight into whether a company is merely being frugal with dividend distribution or is required to withhold earnings for further growth.
Is a particular payout ratio sustainable?
To understand sustainability, another consideration is crucial – a trend of dividend distribution.
Suppose Company ABC has a DPR of 15%, 18%, and 20% in FY 18 – 19, 19 – 20, and 20 – 21, respectively.
This trend shows that the company has been consistent in dividend payout, and the ratio has only gradually increased the ratio over time. It reveals the possibility that maybe that company is moving toward a more stable cash flow and therefore, can afford the payment without compromising growth.
Now suppose, Company BCD has a DPR of 15%, 18%, and 30% in FY 18 – 19, 19 – 20, and 20 – 21 respectively.
A sudden spike in the dividend payout ratio could mean that either the company has realised windfall gains or is expecting to prompt an upward tick in its share price. The latter is an unsustainable approach and can lead to future price drops in its stocks.
Therefore, all these aforesaid considerations are quintessential when interpreting a payout ratio and using it as a basis for comparison.