Dividend Payout Ratio: Definition, Formula and Calculation Explained
The dividend payout ratio illustrates how much of a company’s Profit After Tax (PAT) is paid out as dividends to shareholders in the form of compensation. Dividend payments indicate that a business is earning sufficiently well to share a part of its profits with its owners, which boosts confidence among shareholders.
This blog emphasises on how a company calculates dividend payment ratio and its significance in business.
What is Dividend Payout Ratio?
The dividend payout ratio is a financial metric that shows the total amount of dividends that are paid to shareholders with respect to the company’s net income. In other terms, it’s the percentage of a business’s earnings that are offered to shareholders in the form of dividends.
The money that isn’t utilised for paying dividends is retained either for business expansion or paying off debt. A high dividend payout ratio is an indicator of a company’s capability to share its profit in exchange for business growth.
A low ratio could signal that the business chooses to reinvest the profit in the business for future growth at the cost of existing income for shareholders. Based on the investor’s long-term objective, either of these scenarios can be preferable.
Dividend Payout Ratio Formula and Calculation
There is a commonly used dividend payout formula that you can use to calculate the value of dividends paid out by a company. The dividend payout ratio formula is as follows:
Dividends Payout Ratio = Dividends / Net Income
Let’s understand how to calculate dividend payout ratio:
Example: Company MM has declared Rs.10,00,000 as a dividend to its shareholders on 1st April 2021. As per its Profit & Loss Statement, Company MM has produced a net income of Rs.1,00,00,000 in FY 2021-22.
This means, the Dividend Payout Ratio of company MM = 10,00,000 / 1,00,00,000 = 0.1 or 10%.
It’s also important to note that some people calculate the dividend payout ratio on the basis of per share. In this scenario, dividends per share get divided by earnings per share.
Dividends Payout Ratio = Dividends Per Share / Earnings Per Share
Businesses mostly detail their Earnings Per Share on their income statement, which can be found in the company’s annual and quarterly reports.
Example: Company ABC paid out Rs. 4 per share as a dividend and reported net earnings of Rs.20,00,000. The total number of its outstanding shares adds up to 2,00,000.
Here, since the number of outstanding shares is 2,00,000 and its net earnings are Rs.20,00,000, its EPS would be Rs. 10.
This means, Dividend Payout Ratio of company ABC = 4 / 10 = 0.4 or 40%
Alternatively, the dividend payout ratio can also be calculated as:
Dividend Payout Ratio = 1 – Retention Ratio
Example: Company XYZ records a net income of Rs.50,00,000 in FY 2021-22, of which, it retained 70% of earnings for clearing debts and funding a new project. The rest of the earnings are distributed as dividends among shareholders.
This means, Dividend Payout Ratio of company XYZ = 1 – 70% or 1 – 0.7 = 0.3 or 30%
For those investors looking for a more reliable and automated outcome, using a dividend payout ratio calculator is a better option.
Also Read: What is Treynor Ratio, How is It Calculated and Why Do Traders Use It?
What Does Dividend Payout Ratio Signify?
There are multiple considerations that are taken into account when evaluating a company’s dividend payout ratio, the most important being the extent of maturity and vision a company possesses.
A relatively mid-sized growth-focused company is most likely to reinvest most of its income and would have a nearly zero payout ratio. However, a well-established company may choose to declare a dividend for its shareholders.
Another important assessment of the payout ratio is dividend sustainability. A company could be hesitant to cut dividends as this can impact its stock price and market reputation.
Thus, it is essential to be mindful of a company’s future earning capability and calculate a forward-looking payout ratio.
Long-term trends also play a role when it comes to payout ratio. Remember, a payout ratio that rises steadily indicates a healthy and maturing business.
But on the other hand, a rate that spikes out of the blue can signify that the dividend is stepping into unsustainable territory.
For example, if company DD has a 100% or above dividend payout ratio, it shows that this company is paying more than it’s earning. Such a payout strategy is usually considered unsustainable. But in some cases, it could be that company DD has experienced a few setbacks in a certain year due to which its net income has declined. Yet, to continue its consistency to roll out dividends, the company declared a DPR of 100%.
Therefore, for investors, it’s important to contextualize a ratio against probable circumstances when assessing it.
Interpretation of Dividend Payout Ratio
The dividend payout ratioacts as a guiding tool for investors to determine which companies are doing well and would help meet their investment goals. When investors purchase a company’s stocks, their return on investment comes from two sources – capital gains and dividends. These two sources of return are associated in the following way:
1. Low Dividend Payout Ratio
A company exhibits high growth and reinvests the earnings in the company, either to garner higher market share from larger incumbents or as a defensive mechanism. Consequently, the company issues lesser dividends but improves the chances of a higher share price through other means, thereby causing capital gains for investors.
2. High Dividend Payout Ratio
A company in the later stage of its life cycle issues the higher value of dividends to shareholders rather than reinvesting the earnings in the expansion or growth of the company.
In this scenario, the potential of capital gains for investors reduces. Such companies tend to appeal to growth investors who are seeking considerable profits from a rise in share price and less inclined to dividend income.
The dividend payout ratio is not determined to assess whether an investment in a company will turn out good or bad. Instead, it is leveraged to help investors learn what kind of returns (dividend income vs capital gains) a company can offer.
Analysing a company’s historical DPR enables investors to ascertain if the investment returns align with their risk tolerance, portfolio, and investment strategy.
What is a Good Dividend Payout Ratio?
Though payout ratios are not the only thing an investor takes into account when investing, they do indicate the stage at which a company is in. Generally, a range of 0% to 30% is considered a decent payout.
A higher dividend payout ratio viewed from an investor’s perspective is a great deal. However, it implies more risk and low retained earnings for expansion and growth. A payout ratio that exceeds 75% but is within the bracket of 95% is considered very high. This suggests that the company is on the verge of declaring almost all its earnings as dividends, which in turn increases the risk of the company eliminating the distribution of dividends.
Lastly, companies with forward-looking payouts of 95% to 150% are declaring more dividends than the worth of their earnings. This is likely to cause an unsustainable payout ratio in triple digits. An important aspect here is that investors must prefer healthy payout ratios over high or very high payout ratios. The latter two may seem attractive in the short term but they may not last in the long run.
What is the Difference Between Dividend Yield and Dividend Payout?
Dividend yield can be defined as a ratio that highlights the return rate in the form of dividends. On the other hand, dividend payout indicates how a company pays out its dividend as a part of its net income.
The former is a popularly used financial ratio leveraged by investors to measure the rate of return in the form of dividends and understand the company’s capacity to deliver returns at that rate in the future. Dividend payout, on the other hand, is linked with the cash flow of any company.
Dividend Yield = Dividend Per Share / Price Per Share
Dividend Payout Ratio = Dividend Paid / Net Income
Benefits of Dividend Payout Ratio
There are multiple advantages of dividend payout ratio, some of which are as follows:
- It acts as a guide when it comes to distributing profits in a uniform manner to minimise or avoid conflicts between the shareholders and management authorities.
- The ratio helps investors in decision-making. Based on the dividend payout ratio, investors are able to identify which companies have stable dividend payout ratio that can be relied upon.
- It signals future share price variations. Whether this rate would appreciate or decline will prove to be of help to investors.
Limitations of the Dividend Payout Ratio
The limitations of the dividend payout ratio are as follows:
- It’s not always that the dividend payout ratio may give a realistic picture. At times, you may come across a very high ratio but that may not necessarily indicate a good trend. It may be a scenario where the net income of the company is dropping down and yet it prefers to disseminate dividends to its shareholders.
- Likewise, a lower DPR may not always mean bad because the company might be retaining its earnings for future growth or expansion where chances of profit generation are even higher.
- An investor needs to be cautious and must do a thorough analysis of the company before making a judgement on the basis of this ratio.
Also Read: Risk-to-Reward Ratio: Calculation, Importance and Benefits
Final Word
The dividend payout ratio is an important metric for businesses of every kind, be it big or small, as it helps investors, as well as shareholders, to ascertain how efficient the company is and what is the scope of its future growth.
The only point to keep in mind is the comparison of the dividend payout ratio must be done between companies functioning in the same industry and at a similar maturity stage.
FAQs
Ans. Most companies declare dividends every quarter (four times a year). However, this frequency can vary from company to company. Some companies also pay dividends semi-annually (two times a year), annually, or with no set schedule.
Ans. There are mainly four types of dividends:
a. Cash dividend – this is the most common form of dividend payout,
b. Stock dividend – this is a form of payout when the company issues additional shares to its regular shareholders,
c. Scrip dividend – in a situation where the company does not have enough dividends, it may distribute dividends by issuing promissory notes, and
d. Property dividend – herein, a company issues a non-monetary dividend to its shareholders.
Ans. The high-tax bracket investors (individuals) prefer low dividend payouts, whereas low-tax bracket investors (corporates) prefer high dividend payouts.
Ans. If investors do not receive the dividend, they can claim for its reissuance. Investors can make this claim only up to 7 years from the date on which the dividend was declared by the company. Additionally, a request letter is needed to be submitted to the company’s transfer agent and registrar.
Ans. To state simply, it’s the total value of dividends paid by a company to its investors in a year. The annual dividend signifies the aggregate of dividends or per share paid to the shareholder throughout a year. The annual dividend per share when divided by the share price gives the dividend yield.
Ans. The higher the dividend payout ratio, especially if it’s above 100%, the riskier it is in terms of sustainability. Conversely, a low dividend payout ratio can indicate that a company is reinvesting its earnings in the business for future growth or expansion purposes.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
