What It Is, How to Use It, and How to Calculate It

What Is the Payout Ratio?

The payout ratio is the proportion of a company’s earnings that it pays to its shareholders in the form of dividends. It’s expressed as a percentage of the company’s total earnings or, less commonly, as a percentage of a company’s cash flow.

The payout ratio is also known as the dividend payout ratio.

Understanding the Payout Ratio

The payout ratio measures the reward a shareholder gets for buying and holding a company’s stock. But, a high payout ratio is not always good, and a low ratio is not necessarily bad.

The payout ratio indicates the sustainability of a company’s dividend payment program. It’s the amount of dividends paid to shareholders relative to the total net income of a company.

There’s no single number for an ideal payout ratio. The factors largely depend on the sector in which a given company operates.

Companies in defensive industries such as utilities, pipelines, and telecommunications tend to have stable earnings and cash flows that can support high payouts over the long run. Income-driven investors are advised to look for a ratio in the neighborhood of 60%, but 35% to 55% is considered strong.

Companies in cyclical industries like airlines and automobiles tend to pay out less reliably because their profits are vulnerable to economic fluctuations.

Example of the Payout Ratio

Let’s assume Company A has earnings per share of $1 and pays dividends per share of $0.60. The payout ratio would be 60% (0.6 ÷ 1). Let’s further assume that Company Z has earnings per share of $2 and dividends per share of $1.50. The payout ratio is 75% (1.5 ÷ 2) in this scenario.

Company A pays out a smaller percentage of its earnings to shareholders as dividends, giving it a more sustainable payout ratio than Company Z.

Payout Ratio Formula

$\begin{aligned} &DPR=\dfrac{\textit{Total dividends}}{\textit{Net income}} \\ &\textbf{where:} \\ &DPR = \text{Divided payout ratio (or simply payout ratio)}\\ \end{aligned}$​DPR=Net incomeTotal dividends​where:DPR=Divided payout ratio (or simply payout ratio)​

Some companies pay out all their earnings to shareholders. Others dole out only a portion and funnel the rest back into their businesses. The measure of retained earnings is known as the retention ratio. The higher the retention ratio, the lower the payout ratio.

The payout ratio would be $25,000 ÷ $100,000 = 25% if a company reports a net income of $100,000 and issues $25,000 in dividends. This implies that the company boasts a 75% retention ratio. It records the remaining $75,000 of its income for the period in its financial statements as retained earnings. This appears in the equity section of the company’s balance sheet the following year.

Companies with the best long-term records of dividend payments generally have stable payout ratios over many years. A payout ratio greater than 100% suggests that a company is paying out more in dividends than its earnings can support. This might be cause for concern.

The Bottom Line

If you’re considering stocks that pay a high dividend regularly, the payout ratio is an important number. It’s the percentage of the company’s revenue that is returned to its shareholders in dividends.

However, the dividend ratio is also studied for warning signs that a company is spending too much of its income on retaining shareholders and too little on growing or even maintaining the business.

If dividends are important to your investing strategy, look at companies in defensive industries like utilities and consumer staples, where revenues tend to stay steady in good times and bad. These companies can afford to pay steady regular dividends without neglecting the business.