'Dividend Payout Ratio' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
The Dividend Payout Ratio refers to a ratio of all dividends which have been paid out to the total shareholders as compared to the complete net income of the company. In the end, the percentage of earnings paid to shareholders in the form of dividends is what this amounts to. Any amount of earnings which does not become payable to shareholders remains with the company in the form of retained earnings which the company keeps in order to reinvest for expansion or in other core operations or to pay down their company debt.
This Dividend Payout Ratio may be calculated out as the annual dividend per share divided by the company’s earnings per share. Another way of figuring it is by taking the number one and subtracting the retention ratio.
This Dividend Payout Ratio delivers a figure for the total sum of money which a company gives back to its shareholders as opposed to how much they decide to hold for such things as increasing cash reserves, reinvesting in growth, and paying down debt. This is commonly referred to as retained earnings.
It is always important to consider a number of factors when deciding on how to read the Dividend Payout Ratio. This starts with the maturity level of a given company under consideration. Those firms which are newer and heavily skewed towards growth will want to expand, create and launch newer products, and also attempt to grow into completely new markets. They would naturally keep to reinvest the majority of or even sometimes all of their aggregate earnings. This would excuse them maintaining an extremely low or even zero percent payout ratio.
The same does not go for a company which is older and far better established. If they return only a small percentage of their earnings to the shareholders, then investors will complain. It might not only angry the individual corporate investors, but cause the so-called activists to intervene in the company board and management in retaliation.
Consider the interesting case of Apple. In the year 2012, the technology giant finally started paying a dividend for its first time in around twenty years at that point. It was because the new Chief Executive Officer believed that the enormous cash flow of the tech giant company meant that it was no longer justifiable to offer a zero percent payout ratio. The downside to this decision is it put Apple in the somewhat awkward position of joining the ranks of those corporations which believe they have passed their strong initial growth stage and so make a large dividend ratio payout to compensate. It signals that the company share prices will not likely continue to appreciate rapidly any longer.
The Dividend Payout Ratio has another helpful use. It can be deployed in order to determine how sustainable a dividend is from a given firm. Corporations do not like to cut back their dividends once they establish them. It can cause the stock price of the company to free fall and often reflects poorly on the skills and capabilities of management. When the firm has a higher than 100 percent Dividend Payout Ratio, it means that they are giving back a larger amount of money than they are earning. This would require that they reduce the dividend or eliminate it altogether in the near future.
Companies may decide to ride out a bad year in the market place without cutting their payouts though. This is why analysts like to contemplate the future earnings expectations of a firm to calculate up a forward looking payout ratio in order to put their last payout ratios into better perspective. Longer term payout ratios are similarly significant. Those ratios which are steadily increasing might be indicative of a maturing and growing business. Spiking ones might indicate that the dividend was quickly becoming unsustainable though.