Understanding the Dividend Payout Ratio

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Investors use many different ratios and metrics to assess viable candidates for their portfolios. The Dividend Payout Ratio (DPR) looks at the dollar amount of dividends a company pays out, relative to its total net income.

In other words, it tells you what percent of earnings the company paid out to its owners or shareholders. Any money the company doesn't pay out typically goes to pay down the firm's debt or reinvest in key operations.

Although the ratio offers some insight, companies provide shareholder value in other ways besides dividend payments, so the DPR doesn't always give a full picture of a company's viability.

The Ratio Defined

The dividend payout ratio (DPR) gives investors a view into how much money a company keeps to put back into growth, cash reserves, and debt repayment, versus the amount it gives back to its shareholders. You can calculate the ratio by dividing the yearly dividend by net income.

How to Calculate

You can calculate the DPR by dividing the dividends per share by the company's earnings per share:

DPR = Dividends Per Share / EPS

For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would be 33 percent. ($1 / $3 = 33 percent)

It's All in the Interpretation

The real question is whether 33 percent equates to a good or bad payout, which varies depending on the interpretation. Growing companies typically retain more profits to fund growth, which offers the chance of more favorable dividends in the future, while offering lower or no dividends in the present.

Companies paying higher dividends may be in mature industries with little room for additional growth, so paying higher dividends may be the best use of profits. Utilities used to fall into this group, although in recent years many of them have been diversifying their business lines.

You can infer other information about a company's strength with the DPR, such as the dividend's level of sustainability. Companies have a motivation to pay dividends at a level they know they can sustain, rather than offering an aggressive dividend to please shareholders. Some companies have learned the hard way that cutting dividends upsets shareholders, drives down the company's stock price and reflects poorly on the management team's abilities.

Following a firm's dividen-payment trends over time sheds additional insight. If a company's DPR rises over time, it could indicate that the company's maturing into a healthy and stable operation. Conversely, if the dividend spikes up, it could signal that the company could have trouble sustaining such a high dividend in future periods.

Regardless, it's important to view the DPR in the context of the company, its industry, and its competitors. By itself, the ratio does not offer nearly as much information. Tracking changes in a firm's DPR over time also provides much more meaningful analysis.

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